Building your emergency fund

Have you ever had trouble setting aside money for a rainy day? You're not alone. 25% of people have no emergency fund and another 22% have less than 3 months of expenses saved up. That means that if a major emergency happens nearly half of Americans will end up going into debt. But how do you get started?

First, understand why

The first step in building an emergency fund is to understand why you need an emergency fund. Once you know why, understand that people develop their spending habits over months and years, so deciding to stop wasting money is akin to deciding to end an addiction. You have to have a plan.

Set Goals

Decide when and how much you want to save up so that you know how much you need to save each month. For example, say you decide to save up 1 month of expenses in five months. If you normally spend $2500 a month, then you will need to save up $500 a month to hit your goal. Be realistic with how quickly you can save up. It is better to choose a slow savings amount and hit your monthly savings goal each month than to miss your goal and get demotivated. If you know you can save up only so much a month, set your timeline based on that savings rate.

Limit recreational activities

Choose 1 expense you know you can eliminate, such as a meal out to eat, going to the movies, or some other recreational activity. The day you normally spend that money, instead put the money in your emergency fund account and spend the time doing something cheap or even free. Doing this over the course of several months can add up. For example, say you cut back eating out twice a month for a year where the meals cost $30 apiece. You will have saved up $720, just by slightly altering your spending habits.

Save windfalls

Many people file their taxes and get a substantial tax refund they can use toward building their emergency fund. If you receive a tax refund or some other relatively small windfall, use some of it for fun and put most of in your emergency fund. Take for example the average tax refund: $2,913. You could set aside $213 for fun and put the other $2,700 in your emergency fund. For many people that is a whole month of expenses and could allow them to stop living paycheck to paycheck and start tackling debt.

Pay off debt

Once you have 1 month of an emergency fund you can start working on paying off debt. The quicker you pay off your debt, the quicker you will be able to free up money that you can use to save towards your 3 months of expenses and eventually your six months of expenses. And whatever you do, stop borrowing more money.

Make it automatic

Most employers that provide direct deposit will allow you to direct deposit money into a savings account. The benefit of this approach is that you never see the money in your checking account, and as a result never feel the urge to spend it. If you are don't like the idea of not immediately having the money available, you could setup an automatic transfer shortly after payday. Making your savings automatic forces you to save and helps for the times when you would otherwise forget to save money.

Get a second source of income

Nothing helps build up emergency savings like having more money available to save, and a second source of income would provide just that. You could do anything from a getting a part time job, to selling your stuff online to tutoring students. The options are just about endless.

Sell your car

If you have a car with significant value sell your car and buy a cheap one. Doing so could help you add several months worth of savings to your emergency fund. If you have a car payment, get rid of it and buy a cheap one. Then use the freed up money each month to put towards your emergency fund.

Cut the cable

We did this and we have saved ourselves over $700. You may still be able to see many of your favorite TV shows and sports using just an antenna and free online services.

Use it only for emergencies

An emergency fund is for unforeseen emergencies, not for holiday decorations, vacations, prom dresses, or birthday gifts. Set up a short term savings account and put money aside each month for the things you know will come up. A little bit of planning will help you avoid dipping into and draining your emergency fund.

This is only a small sampling of ways to help buildup your emergency savings. What methods have worked for you? What didn't? Feel free to discuss.

Emergency Funds

Why have an emergency fund?
One of the core components of a healthy financial plan is an emergency fund. Many financial experts even recommend the emergency fund be your first financial goal. I agree with this sentiment. But why exactly should you have an emergency fund?

The main goal of an emergency fund is to cover unplanned expenses (aka emergencies) that arise so that you don't have to go into debt to cover those expenses. In particular, there are several different common major emergencies an emergency fund can cover:

• Car repairs and car replacement
• Medical visits and emergencies
• House repairs such as flooding and fires (if your home insurance doesn't cover or doesn't pay out immediately)
• Loss of job, or a loss of income do to disability, pregnancy, or some other emergency
• Expenses associated with family emergencies and tragedies
• Many, many other events that cost nontrivial amounts of money

So how much should you save up?
Ask 10 different financial experts and you will get 10 different recommendations, of which the most common are:

• Based on a number of months of expenses, typically 1, 3, 7, or 8 months
• Specific amounts, such as $5,000 or $10,000
• One year of expenses
• Whatever you feel "comfortable" setting aside or whatever is right for you

Some experts, such as Dave Ramsey, recommend a combination of the above in a step wise manner. He recommends first saving up $1000 in your emergency fund, paying off debt, then saving up 3 - 6 months of expenses. I agree with Dave with his methodology of first starting an emergency fund, paying off debt, then finishing up the emergency fund. But I disagree with the amounts.

Rather than first saving up $1000, I recommend to first stop living paycheck to paycheck by saving up one half to one month of expenses. Once you have it saved up, then you should be able to cover situations such as minor car repairs, buying a beater car if your car needs to be replaced, a doctor visit, a loss of job or disability for up to one month, and expenses associated with family emergencies. Keep half of your money in your checking account and the other half in either a traditional or money market savings account. This will help cover some emergencies where you don't have time to transfer the money from the savings account to the checking account and will prevent you from over-drafting in such an event. It will also prevent you from over-drafting if the timing of paying your bills doesn't work out exactly as planned and a large bill is paid the day before payday.

After you have paid off your debt, save 3 months of expenses. The three months of expenses would be able to cover the estimated average out of pocket maximum towards medical expenses (1) before health insurance pays out, loss of job or disability for three months, and cover some substantial house repairs. At this point I recommend to start saving 10% of your income towards retirement.

But your emergency fund still isn't complete yet. Why? Because 3 months of expenses doesn't cover the average duration of unemployment. From 1948 until 2008, the average duration of unemployment was between 7 and 20 weeks (2). If you save up 6 months of expenses, then you should be able to cover all of your expenses long enough to get a new job. It will also help cover many major house repairs and cover your expenses up until long term disability insurance kicks in, which is usually around 6 months (3). Once you have set aside 6 months of expenses, your emergency fund is complete.

References:
(1) http://www.goinsurancerates.com/health-insurance/out-of-pocket-expenses-series-maximum-limits/
(2) http://economix.blogs.nytimes.com/2011/06/03/average-length-of-unemployment-at-all-time-high/
(3) http://employeebenefits.about.com/od/ancillaryinsurance/a/LTDBasics.htm

Advantages of Multiple Savings Accounts

Have you ever asked your self, "Where did the money I saved for... go?", or "Hmm, I can't tell how much money I set aside for ...?" Chances are you need multiple savings accounts.

Multiple savings accounts help you keep your money organized. Each account has its own balance and transaction history. This allows you to quickly, and clearly, see which money is set aside for which expense without have to dig through one monolithic transaction history of one account. They also provide an explicit barrier between your accounts. You are much less likely to accidentally spend money for one expense that you have set aside for another simply because the check or debit card you use simply wont affect the account that hold the other expense.

Multiple accounts also provide a layer of protection from thieves. If someone manages to get a hold of your debit card or checkbook for your checking account or one of your savings accounts, your money in the other savings accounts would be protected. The thief would not have immediate access to that money in the other accounts.

If your bank imposes transaction limits on your savings accounts, they may impose the limit on individual accounts rather than one transaction limit for all savings accounts. If so, setting up multiple accounts effectively multiplies the allows number of transactions you can make before you hit your transaction limit. In addition, some banks do not impose limits for transfers made between savings accounts online, making it easier for you to reassign money as you like. Check with your bank to find out their savings account transaction limit policies.

If you have been avoiding setting up multiple savings accounts because of the hassle factor, then you would be pleased to hear that creating new savings accounts are easier now than ever before to setup. Many banks now provide options to quickly setup additional savings accounts online without having to go through the effort of filling out paper work or driving to a branch. You could even choose an online bank so you never have to leave the house.

So how should the money be broken up?

At a minimum, put your emergency fund in a separate savings account. This guarantees that every time you take money out of the account it is intentional. This account would be a good choice as a high yield savings account since the balance should be relatively high and steady.

After you have setup your emergency fund account, the next step would be to split your savings into a short term savings account and a long term savings account. The short term account could hold expenses that usually take less than a year to save up and are relatively small expenses. For example, this account could hold things such as quarterly insurance premiums, money for Christmas gifts, or any other lump sum expense you plan to make throughout the year. The long term savings could hold things that take are major expenses, such as vacations, car replacement, furniture replacement, or down payments for house. Many people decide to go even further and breakup their long term savings into more accounts for specific goals to keep track of the balance for each goal.

Regardless of how you much you separate out your savings, the point is that you keep track of your savings. If it's easier for you to keep track of just one savings account, then have just one savings account. If keeping track of your savings in one or a few account, then split it out into more. Just know where your money has gone, where it is, and where it will go.