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Build an Emergency Fund to Fend Off Debt

How and Why to Build an Emergency Fund

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Build an Emergency Fund to Fend Off Debt
© Steven Puetzer/Getty Images

What do you when your car needs major repairs and you don't have the cash to pay? If you have a credit card in your wallet, you probably charge the repairs and pay them off sometime in the future. Using a credit card for emergencies is risky because that emergency balance can morph into debt before you know it. This is why you need an emergency fund.

What's An Emergency Fund?

An emergency fund is cash savings that you can access quickly and easily in emergency situations - unexpected but absolutely necessarily expenses. A good emergency fund savings usually ranges from three months to a year's worth of living expenses, that is, the monthly amount of money you need to survive each month. So, if your living expenses are $1,500 each month, your emergency fund might range from $4,500 to $18,000.

The primary purpose of an emergency fund is to carry you in periods of unemployment. Emergency savings can also be used to cover unexpected expenses when you don't have the cash in your primary checking account. Your emergency fund should not be used to buy new furniture, fund lavish vacations, or pay for other luxuries. If you use your emergency fund for non-emergencies, it won't be available for real emergencies.

How To Build An Emergency Fund

Building an emergency fund takes time, depending on your monthly discretionary income or the amount of money you have left over after paying your bills each month. These are the basic steps you should take to build your fund.

  1. Decide how large you want to build your emergency fund. Three months of living expenses? Six months? One year? You can always start with a goal of three months living expenses and, once you've reached it, create a bigger goal to save six or twelve months of living expenses. If three months of living expenses seems unreachable, start out with a smaller goal of $1,000. Even that will help.
  2. Determine how much you can put into your emergency fund each month. Your monthly budget will be useful in this step. If you don't have one, now's a good time to build it. Remember, your emergency fund savings comes from your discretionary income.
  3. Open a separate savings account for your emergency fund. Keep your emergency fund separate from your active checking and savings accounts. This way you'll be less tempted to dip into your fund unless there is truly an emergency.
  4. Start building your emergency fund. Put aside money every pay period until you've reached your goal. Make emergency fund contributions a priority. If you can save automatically via direct deposit or automatic transfer, it will be much easier.

Tips to Build Your Emergency Fund Faster

  • Anytime you get extra, unexpected money, like a bonus or a tax refund, put it in your emergency fund to reach your goal faster.
  • If you get a raise at work, put the increase towards your emergency fund rather than increasing your standard of living.
  • Reduce your spending, as you're able to, and funnel the savings to your emergency fund.
  • Put your emergency fund in a high-yield savings account or CD to earn a little interest on your savings.
  • Keep a change jar or piggybank for spare change. If you use cash a lot, the change will add up quickly. Some people even save their $1 bills.

When Can You Use Your Emergency Fund

You should use your emergency fund only in real emergencies. For example:
  • You've lost your job and need to cover the mortgage and other bills.
  • You have unexpected medical expenses not covered by insurance.
  • Your lender calls your car loan due and will repossess your vehicle if you don't pay immediately.
  • Your refrigerator breaks down and needs replacement or repair.

Emergencies are severe situations that require immediate action. The consequences of not handling the emergency would threaten your safety or basic physiological needs.

You should not use your emergency fund for things you simply want to purchase. For example:
  • The latest XBox or Playstation game system.
  • A new set of luggage.
  • A new coat of paint for your car.
  • Gifts for friends or family members.

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