So, you want to get your finances in order, but you don’t know where to start? Well in my opinion the first place to start is by building an emergency fund.

All of us will face financial emergencies that could include being fired, having a vehicle break down, or having to travel a great distance at the last minute (say for a funeral of a loved one). Without careful planning these emergencies can put a great strain on your bottom line and even cause you to rack up some bad debt in order to cope. An emergency fund is your key to avoid going into debt (or worse) when such an emergency happens.

The general consensus seems to be to set aside around three to six months of living expenses in an emergency fund, somewhere that provides a decent return on your money and easy (but not too easy) access to your funds. I personally keep mine in an ING direct savings account, currently at 2.4% (in Canada, rates are currently 2.8% in the US). Other options include money market funds and CDs (certificates of deposit, not compact disks) used in combination with a high-yield savings account to provide a balance of return on investment and fast access to funds.

For example, let’s say you fine a good rate on a one-month CD or money market fund, and you have built up three months worth of living expenses in your emergency fund savings account; you can place two months of living expenses in the CD or money market fund, and still know that if you were fired the next day, your savings account emergency fund would last you until you had access to the remaining two months. If you encounter an massive emergency expense you can always draw the CD or money market fund early, you usually just lose the accrued interest in the process, perhaps with some fees or penalties as well.

Placing money in CDs and money market funds also has the benefit of slowing access to your emergency money. Remember, a nice pair of shoes on sale is not an emergency.

So how much is three months of living expenses? Many just use three months salary as a figure, and I think that is fine in most cases. You could also evaluate your spending and trim some of the fat for your three-month figure. After all, you probably will not eat out a lot if you are fired, so you could remove dining expenses from your three month figure (having an application like Quicken can help determine your current spending habits and identify spending that can be cut).

Once you know how much of an emergency fund you need, how do you build it? A simple principle is to pay yourself first: take 10% of your take-home pay and put it in your emergency fund. Once the emergency fund is in place you can redirect that 10% to savings and other investments, but focus on first preparing for the rainy days to come. You may wonder if you can get by on 10% less money, but in my experience most people’s spending is like a goldfish: just as a goldfish only grows as big as the tank containing it, most people’s spending increases and decreases according to available funds. If you take the money out first, your remaining discretionary spending will shrink to match.

There are some specific suggestions on making room for emergency fund money in an article at bankrate.com:

“Do an energy check on the house. Replace cracked storm windows, renew the weather stripping. Don’t renew subscriptions to magazine or newspapers you’re not reading. Eat out less often, learn how to use leftovers. If you stop at Einstein’s every morning for coffee, make coffee at home.”

And, Grzymala adds, “When the 12 year old says, ‘Where’s my $10?’ cut it back to $7.”

There is some advice that revolves around borrowing against various sources to build an emergency fund that I disagree with; you should not borrow from Peter to pay Paul, just pay yourself first and in time your emergency fund will be an adequate size.

Even if you never have to use it, your emergency fund will grow and you will benefit from increased peace of mind that comes with working over a safety net. For example, how much less stressful could your job be if you were not in fear of the financial repercussions of taking risks and getting fired?

This entry was posted on Thursday, March 24th, 2005 and is filed under Banking, Financial Planning. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.