No matter how we may plan, stuff happens. Your glasses break. Your car needs work to pass its emissions test. The water heater goes out.
Your employer announced layoffs – and you’re one of the victims.
Life just keeps happening, whether we want it to or not, and it seems like unexpected expenses show up more often than windfalls. That’s why you need to budget for them as much as possible. If not, you’ll end up turning to credit cards or – worse – a payday lender, making your financial crunch much worse and lasting much longer.
The way to budget for setbacks is to keep money in an emergency fund. The usual guide for an emergency fund is to have three to six months of living expenses readily available. This (should be) less than your current salary and includes your rent or mortgage payments and utilities; your car payment, gas and insurance premiums; minimum payments on credit-card debt and other loans; and the costs of food, medicine and toiletries.
Here are four ways to start building an emergency fund:
1. Before you start an emergency fund, you should have a handle on your expenses. If you don’t have a budget, start by going through your checking account statement or your credit-card bills.
2. Make sure you aren’t handling regular expenses as though they are emergencies. I’m not talking about the light bill, but rather such things as car insurance and birthday presents that crop up on a regular basis. It’s easy to forget about regular expenses that don’t occur monthly. Even though each nephew has a birthday only once a year, how often do you have a niece or nephew with a birthday?
3. Start small, setting aside a little bit of money each paycheck. As you save the money, put it into an account that is separate from your regular checking account. However, it should be in a very safe investment, such as a bank account or a money market mutual fund. You won’t get much return on the funds, but that’s OK. You want money that will be there when you need it. (If you don’t have enough money to avoid a service charge, keep the money in an envelope in the freezer, where it will be safe from fire and just a little difficult for you to reach.)
4. If you accumulate enough money in your emergency fund, you may be able to get a higher interest rate by putting some of it into bank CDs. Yes, CDs usually carry a penalty for early withdrawal. That penalty comes in the form of a reduced interest rate, though, not a fee for cashing in the money. That means that if you have enough money set aside that you can get a CD with a higher interest rate, go for it; if you need the money, you can always cash in the CD and give up a little bit of interest.
You may notice something interesting: As you get better at reducing your expenses and paying off debt, the amount of money that you need in your emergency fund gets smaller – and you’ll find it easier to pay unexpected expenses from your regular income. That gives you more power over your finances, although not over life itself.
With any luck, the emergency fund will be money that collects a little bit of interest and nothing more. However, if life takes weird turns, as life so often does, you’ll be able to turn to this money instead of to your plastic.