The Importance of an Emergency Savings Fund

There's a general rule of thumb when establishing an emergency savings fund: the size of your fund should be equal to at least three months' worth of your living expenses. Take note that it's three months' expenses, not three months of your pay. And when calculating those expenses, be sure to focus on your needs and not on your desires.

Different people earning the exact same salary may have widely dissimilar monthly obligations. If you have no children, for example, and no family members that depend on you financially, no credit card debts or car payments to make, and your mortgage is paid off or at least quite manageable, you can probably afford to save less and invest more of your money. On the other hand, if you have three children to support, along with a sizeable car payment and credit card bills to cover, your emergency fund should perhaps be a bit larger than the rule. It's therefore critically important to sit down and actually calculate your monthly expenses.

The whole point of an emergency savings fund is to be able to meet your obligations, not your desires. This means that you should focus on the necessities to keep your household afloat; things such as your monthly mortgage and car payments, utilities, insurance, food, and health care. And don't forget to include other important basic needs, like monthly maintenance costs for your home and car, along with taxes. Additionally, it may be prudent to add in an extra amount as cushion when it comes to insurance. If you should lose your job, your health-care costs will likely increase, and substantially so. This could also hold true for life insurance, since you may no longer have access to an employer's group life coverage.

Because your bills won't be exactly the same from month to month - your utility usage can certainly vary, for example - be sure to write down everything you spend for three months and then average your expenditures in order to arrive at a reasonable estimate of your monthly needs.

With these things in mind, there are a few caveats to consider with the three-month rule. For instance, during economic downturns it would be wise to increase the size of your emergency holdings to at least six months of living expenses. This is because the chances of you losing your job (which is, of course, one of the main reasons for having emergency savings in the first place) will rise during such times. Emerging from the Gulf War recession of the early 1990s, the nation's unemployment rate rose from just over five- to just under eight percent. Similarly, following the September 11th terrorist attacks, the U.S. economy dumped more than two million jobs, pushing the unemployment rate up from 3.9 percent in 2000 to over 6 percent in 2003. And although six percent unemployment is still generally considered to be low, when one of the jobs lost is your own, it's an emergency. Additionally, studies have shown that it can often take more than four months to find new employment. Needless to say, in cases like this a three-month fund might not be quite enough.

Stashing the Cash

Once you've got your fund built up, the question may naturally arise, "Where should I keep the money?" Remember that this is your emergency savings, not your emergency investments. None of this money - not a single dollar of it - should be placed in the stock market, not even in the most well diversified, blue chip stock fund out there. Keep in mind that you'll always be better off when you match your money with your financial needs and goals.

The less time that you have to work with (in other words, to make up for any monetary losses, should they occur), the more conservative you should be with your money. For instance, money that you know you'll need to use within in a year or two should be put into the most conservative and accessible asset available, which is cash. Funds that you won't need for two to five years should be allowed to grow, but they should be held in moderately safe securities such as short- and intermediate-term bonds, so that there's little chance of your investment's value diminishing during that period of time. Money that you're not going to touch for five years or more should be invested more aggressively in order to meet your long-term financial goals and beat the ongoing effects of inflation.

Because you could suddenly face an emergency tomorrow, logic dictates that an emergency fund must be held in an extremely safe short-term account. Though fixed-income investments, or bonds, are inherently safer than stocks, they still may not be safe enough to rely on for emergencies. You want an account that offers total protection for your principal. One option is a bank Certificate of Deposit. The problem with CDs, however, is that although they're federally insured, you could pay substantial penalty fees for withdrawing your money early. And you never know; an emergency could arise long before your one- or two-year CD matures.

A bank money market account may be a better alternative, especially if you shop around for one offering above-average rates. Like CDs, money market accounts are federally insured, but you have more ready access to your funds. Typically, a bank will allow you to withdraw money from these accounts three- to six times a month without penalty, which should generally be flexible enough for most emergency purposes. Or you could simply open a regular passbook savings- or interest-paying checking account. Of course, these are likely to be the lowest-paying places that you could put your money, though safety and accessibility are extremely high.

If you're looking for a little more yield while your money is sitting, you might consider a money market mutual fund. A money fund, as opposed to a money market account, is a portfolio that invests in a diversified collection of extremely short-term debt securities. By law, the average debt maturity held in these funds cannot exceed 90 days, which means that they're generally quite low risk and very stable. However, unlike CDs and money market accounts, money funds aren't insured by the FDIC. To compensate for this area of slightly higher risk, they tend to pay slightly higher rates of interest.

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