Image credit: Pen Waggener; CC BY-S.A. 2.0
Every family, rich or poor should put some money aside for that proverbial rainy day as part of an emergency fund. It is one of the most essential parts of anyone’s financial planning and if you haven’t already done it you should start straight away. No one plans on having to use money in emergencies because most people, particularly when they are younger, don't plan on emergencies happening.
Often we feel so invincible, both financially and in ourselves, that we can’t foresee why we might suddenly need hundreds, or even thousands of dollars. But an emergency fund is for exactly such emergencies, the ones you simply cannot plan for. It offers cover for that rainy day and a soft landing when everything starts to crash around you. This article will offer some basic rules on planning an emergency fund:
Rule one: Pay off large debts first
This goes against what was said above about starting an emergency fund straight away but the fact is that if you have significant outstanding debts, particularly ones with high interest rates, then it is counter intuitive to save money whilst building up larger and larger debts. Clear those debts as quickly as possible and then start on the emergency fund.
Rule two: Calculate your monthly outgoings
The first step of an emergency fund is to work out how much you need to save and the best way to do that is by working out how much your monthly outgoings come to. If you are saving for a family rather than just yourself then you need to calculate the monthly outgoings for the entire family. The simplest way to do this is work out how much leaves your basic checking account on an average month. This will invariably include the groceries, travel, school items, money to eat out, pocket money and other assorted items.
Rule three: Calculate the cost of your rent or mortgage
Next it is essential to add the cost of your rent payment or your mortgage payment. This should be a fairly consistent figure, so write it down, allowing for any future increases.
Rule four: Add the monthly outgoings to the mortgage payment
Rule five: Write down potential house repairs
It is worth contemplating any potential house repairs that might be around the corner. Is the roof in a state of disrepair? Does the boiler need replacing? These are the kinds of thing that might present themselves as an unexpected emergency so it is worth calculating what repairs might need doing and how much they might cost. Many people work on the basis that it is worth keeping between 2-3% of the total value of your home in an emergency fund for repairs.
Rule six: Plan for loss of income
This, perhaps is the most important rule of all. One of the biggest financial emergencies that can happen is losing your job and income and being out of work for some time. If you really want to plan an emergency fund it is worth contemplating up to six months out of work. Work out how much you need to find for six months worth of rent / mortgage payments and six months worth of monthly outgoings. This is a severe worst case scenario, but it is the best way to have a proper emergency cushion/
It might be that saving up that amount of money will take you years, but even a tiny bit each month is better than nothing and after just a few months you’ll have a fund that could help when you need it most.
About the author: Esther is a financial journalist and legal blogger based in Chicago. She writes about all areas of personal finance affecting the consumer from tax relief to credit and store cards and from consumer law to where to find a Chicago personal injury lawyer.