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. The problem is that "sometime in the future" may not fit with your current budget and will likely become "sometime in the distant future." 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. The emergency fund savings usually ranges from three months to a year's worth of living expenses. 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. It can also be used to cover unexpected expenses when you don't have the cash to pay. Your emergency fund should not be used to buy new furniture or fund lavish vacations. If you use your emergency fund for non-emergencies, what will you do for real emergencies?
How To Build An Emergency Fund
Building an emergency fund takes time, depending on your monthly discretionary income. These are the basic steps you should take to build your fund.
- 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, lengthen the emergency fund goal to include six months living expenses.
- 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 - what you have left after taxes and necessary expenses.
- 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 emergency fund unless there is truly an emergency.
- Start building your emergency fund. Put aside money every pay period until you've reached your goal. If you can save automatically via direct deposit or automatic transfer, it will be easier.
When Can You Use Your Emergency FundYou should use your emergency fund only in cases of emergency. 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.
- The latest Nintendo game system
- A new set of luggage
- A new coat of paint for your car.