It’s not glamorous or financially “sexy,” but finances rarely are. I’m talking about the less appealing elements of building a sound financial plan. For most families the first action item is to build an emergency fund.
The drill is fairly straightforward, but building an emergency fund is often reliant on manually moving money from each paycheck into a separate checking or savings account...with a rock-bottom interest rate. By month’s end, a meager 20 cents of interest has trickled into your account. Yipee.
In this post I’ll tell you how to build an emergency fund more successfully and how to earn much more interest on your savings, while still keeping your emergency fund safe and accessible.
1. Think about what your “emergency” is
The first question to ask before building an emergency fund is What is your emergency situation? For most families, a true emergency is a financial challenge which significantly decreases or eliminates your immediate or future cash flows. This is typically the loss of a job, but not always. The death of a family member, appliance replacement, and major, unexpected travel costs are other purposes served by an emergency fund.
“A true emergency is a financial challenge which significantly decreases or eliminates your immediate or future cash flows.”
How will the mortgage be paid? Who’s putting food on the table? How will the heating bill be paid? These and other “essential expenses” factor into almost everyone’s emergency situation. Before building a fund, consider what your emergency situation looks like.
2. Calculate your monthly essential expenses
Once you have an idea of the emergency situation, list out all of your “essential expenses” and add up their monthly costs. These will likely include:
- Mortgage/Rent
- Loan payments
- Utilities
- Groceries
- Mobile phones
- Insurance
- Fuel
- Charitable giving
- Netflix--just kidding! Or am I?
Listing the essentials will lead you to reviewing your budget to see what the actual costs will be. Essential expenses typically make up around 50-60% of one’s budget. Whatever your percentage is, total up the amounts needed for any given month.
3. Decide how big of a fund you need
At a bare minimum, an emergency fund should cover 3 months of your essential expenses. A healthier cushion would cover 6 months. As a general guide, you can look to your overall job security as a guide. How confident are you to be able to find a new job in 3 months? In 6 months? Are you willing to relocate to a new city to find something faster?
“Be Prepared... the meaning of the motto is that a scout must prepare himself by thinking out and practicing how to act on any accident or emergency so that he is never taken by surprise. ”
All else being equal, the more stability of your professional expertise and the more willing you are to relocate, the smaller your emergency fund needs to be.
4. Automate your savings
At the start of this article, I noted how building an emergency fund is too reliant on manual methods. You may be really careful with your money, but most of us should embrace a simple financial truth: Once our money hits our checking accounts, it’s gone.
The remedy is to automate the savings. Once you know the required size of your emergency fund, set up an automatic payment from your checking account at a set time each month, preferably at the beginning. This feature is available through most banks’ websites, and you can move money from one bank to a different bank (which is important in the next step).
5. Direct your savings into a high interest savings account
Checking and savings accounts aren’t known for their whopping interest rates these days. Being in a “low-interest rate” economic environment will do that. But it doesn’t mean there aren’t higher interest rates out there, with the same FDIC insurance protection.
For example, I opened a savings account with Ally Bank for my emergency fund. Ally Bank pays 1.20% as of the date of this article. That’s many times more than your checking account and it can result in a nice chunk of interest each month. An emergency fund of $20,000 would earn $20 per month, or $240 per year! Trust me, your checking account isn’t earning that.
If you’re still building your emergency fund, you can set up an automatic deposit to go from your checking account to your high interest savings account so you don’t have to remember to make the deposit each month, and so you’re not tempted to spend the cash elsewhere.
6. Reinvest the interest
As your emergency fund continues to grow and build interest, you can either withdraw the interest for separate investing or spending, or allow it to compound. Taking advantage of compounding interest is often worth it, but your needs for the “extra” cash may be different than others. Kellie and I typically use our interest for buying Christmas gifts each year.
I hope this article helps you understand the added power behind an emergency fund. Using a high-interest savings account for your fund typically allows you to build more interest over time, compared to a traditional checking account. This interest isn’t small peanuts! It can make a big impact, especially when left to compound and continue to build.