Establishing an emergency fund reserve is one of the most basic and critical steps toward building a secure financial future. An emergency fund reserve is money set aside in a liquid savings vehicle to be used for unexpected expenses or for all expenses when not earning income. Having a reserve fund allows you to pay for those unexpected expenses without going into debt. Did a major appliance suddenly quit working and you need a new one? Did you accidentally get injured and need medical care? Did you get laid off from work and loose your only source of income? These are all reasons you might need an emergency fund. Any liquid cash you have available can be a good start toward maintaining an emergency reserve. If you do not have any liquid savings, start building your reserve now.
When building an emergency fund reserve, one must determine how much should be saved into the reserve. The size of an emergency reserve is usually described by how many months of expenses the reserve could cover for the individual. The suggested average in the financial world is somewhere around three to six months of expenses. Some might need less; many could probably use more. The answer will differ depending on individual circumstances, mainly relating to a person’s budget. If regular monthly expenses can be easily lowered when emergency expenditures are necessary, that person may not require a very large emergency reserve. This assumes the person’s budget is comprised of mostly variable discretionary expenses, which is usually not true with most budgets. People with insecure employment or irregular sources of income are in greatest need for large emergency fund reserves. Those who have very few committed costs and can rely on their families or other financial resources during emergencies probably do not require as large of reserve.
Individuals or families may have difficultly building an adequate emergency fund reserve if their expenses are high. A family who brings home income of $3,000 per month after-tax and has monthly expenses of $2,700 will have only $300 per month to save. Saving $300 per month into an emergency reserve would take 27 months (over two years) to build a three month reserve. The family’s savings rate of 10% meets the suggested minimum, but they could attain their reserve goal faster by lowering their lifestyle expenditures. If the family could lower monthly expenses to $2,400, they could save $600 per month and build a three month emergency reserve in only 12 months time.
Another important factor when building an emergency fund reserve is deciding what savings instrument to use. The primary determinate should be liquidity. In the case of an emergency, the reserve funds will need to be accessed in a timely manner, a few days at most. Checking accounts are probably the most liquid place to keep money, but with low to no interest earnings, they can hardly be considered savings instruments. Maintaining an emergency reserve within a checking account used for regular expenses can present an additional problem if the account owner begins to pay regular expenses with money reserved for emergencies.
Savings accounts usually pay a little more interest, and can be a good way to separate money reserved for emergencies. Most banks that offer checking accounts will also offer savings accounts, but the interest rates on those savings accounts are usually pathetic. If you are hunting for a savings account that earns fair interest, I would suggest looking at high-yield online savings accounts. A couple of internet bank savings accounts are ING Direct and HSBC Direct. These online banks are FDIC insured just like brick and mortar banks, but they can usually offer better interest rates because they have lower operating costs by being offered only on the internet.
Another location for saving the emergency fund reserve can be money market deposit accounts and money market mutual funds. Money market deposit accounts are similar to savings accounts in that they are held at banks, but money market accounts limit transactions and offer marginally better interest rates. Money market funds are held at investment companies and technically carry more risk since they are not FDIC insured. Money market funds maintain a stable value at $1 per share, so the principal balance does not decline. In theory, money market funds should provide better interest rates than savings accounts, but I have not seen much difference when comparing them to the high-yield online savings accounts. The advantage of money market funds being held by investment companies is that they can be linked to other investments held at the same company, making transfers between accounts very convenient.
Regardless of where you decide to maintain your emergency reserve, the most important point is that you save money. Even if you stick some cash in a tin can and hide it under your bed, which is not the best choice, at least you are setting aside money for future expenses. When an emergency comes, you can use the reserved money for the necessary expense rather than going into debt and paying lots of interest. Be sure to replenish your emergency fund reserve to an adequate level after you withdrawal any money for emergency expenses. If your regular monthly expenses increase, be sure to increase your emergency reserve amount accordingly. I doubt you will be so lucky as to never have an emergency need expense, but hopefully an emergency fund reserve can provide you some peace of mind in the event you do.
