How to build the perfect emergency fund
Just a few days ago, I was surprised to discover my clothes dryer had completely stopped working. The machine had no other signs of wear and tear and was only a couple of years old. To make a long story short, after a quick call and visit from the repairman, I found myself stuck with a $200 bill. Luckily, with the help of my emergency fund, I was able to cover the expense without falling back on credit cards or disrupting my regular take-home pay. It's like nothing even happened.
Unfortunately, many people aren't adequately prepared to manage paying for an unexpected expense or emergency. According to the Federal Reserve's 2014 Survey of Household Economics and Decisionmaking, 47 percent of Americans say that they wouldn't be able to cover a $400 emergency expense. That lack of preparedness could lead to maxing out credit cards, taking out expensive short-term loans, or worse.
So to help you better manage the unexpected, here's my guide to putting together the perfect emergency fund.
Start small
While you should eventually build an emergency fund that can handle more serious emergencies (economic downturn, loss of job, etc), you're going to want to start by putting together a short-term emergency fund.
Your short-term fund is meant to take care of unexpected expenses that, while not severe, can still mean trouble if you aren't prepared. Things like a car repair, replacing a broken window, or getting a parking ticket are all things that can be covered by your short-term fund. Ideally, you'd want this to range anywhere from $500 to $1,000.
Figure how much you’ll need in the long run
Chances are, if you find yourself out of work, the victim of a natural disaster or unable to work for any reason, $500 to $1,000 won't be enough to keep your head above water. So to make sure you can keep yourself (and your family) financially stable for an extended period of time, it's best to save anywhere between three to six months' worth of expenses. That may sound like a lot of money (and in most cases it is) but believe me, having something to fall back on will make your recovery process all the more easier.
Building yourself a budget is a great way to figure out how much you should aim to save for a long-term emergency. Figure out what expenses you'd really need to cover (food, shelter, major utilities) and which you can do without for a short period of time (cable bill, online subscription services, etc). Once you get that number, you can start working out a savings plan for yourself depending on how much you're able to sock away each paycheck. It might take a lot of time, but having a specific number in mind can really help to keep you motivated.
Tighten up your budget
If you're struggling to come up with money to put away for an emergency fund, there's no better way to boost your cash flow than by tightening up your budget. Writing a concise list of your needs and wants can help you identify what areas of your budget you can cut back on. Think of all the extra money you could save just by cutting back on dining out or going without Netflix for a couple months. Once you've met your savings goal, you can transition back to your regular spending habits with the peace of mind that you'll be able to handle almost anything that comes your way.
Drop your debt
While you'd ideally want to take care of both simultaneously, paying down debt and saving money isn't something that's feasible for everyone. In situations like these, it may be in your best interest to prioritize paying down your debt. The longer you carry debt, the more interest it builds and the more you'll have to pay over time. Taking on high-cost debt (credit card debt, for example) can also be an emergency in and of itself and be a huge drain on the emergency fund you worked so hard to build.
Furthermore, carrying a high balance on your credit card can have a negative impact on your credit. And the lower your credit score, the more likely you are to get higher interest rates on future loans and credit cards. You can see how your debt is affecting your credit scores for free on Credit.com, with updates every month so you can track your progress.
Getting out of debt, and avoiding unnecessary forms of it, can help you maximize your contributions to your emergency fund and ensure it's there for when you really need it.
Most people don't realize how important an emergency fund really is until they're actually faced with a serious emergency. Putting in the time and effort to build an adequate emergency fund is a simple way to make sure you and your loved ones won't fall into debt. So do yourself a favor and take the time to evaluate your expenses, build a budget, and start saving today!