Saving

Emergency Fund 101: How to Start Saving for a Rainy Day

rainy day

Since we were kids, most of us have heard from our parents and grandparents about “saving for a rainy day.” The idea is that you need to put money aside when times are good so that you’ll have some money for when times are bad.

Somewhere along the line, that concept was lost on many Americans and savings rates have plummeted. Recent surveys also indicate that more than half of Americans would even have trouble coming up with $1,000 in the event of an emergency.

A solid emergency fund is perhaps one of the most important tools in developing and sustaining financial security. Most financial experts recommend having between three to six months of living expenses socked away because no matter how well things are going, bad things will happen from time to time.

Why do I need an emergency fund?

It doesn’t matter how much money you make or how well you plan things out in life, bad things happen from time to time.

A hot water heater can spring a leak and flood a room. Your vehicle might break down and need a $1,000 repair or you could come down with a nasty sickness and rack up medical bills.

In any case, all of these things are going to cost money. Mari Adam of Adam Financial Associates in Boca Raton, Fla., says no matter how well things are going, problems can arise.

“These things happen. You can’t always be prepared for the emotional toll or the hassle but you can be prepared to handle the bills,” says Adam.

Your “emergency fund” is money you stash away for the sole purpose of handling emergencies like these. Adam says the fund should be in an “easily-accessible” account, usually a savings account, so the money can be accessed without penalty in a day or two.

It sounds simple but survey data reveals it’s anything but that for many Americans. According to a 2011 survey by the National Foundation for Credit Counseling, 64% of Americans don’t have enough cash on hand to handle a $1,000 emergency.

To handle the crisis, 17% of respondents said they would borrow from family or friends. Another 17% said they would neglect existing obligations, 12% said they would pawn or sell belongings and 9% said they would get a loan from a cash advance store.

Cathy Pareto, a financial advisor in Coral Gables, Fla., says in any case, the lack of an emergency fund not only creates financial stress, but it drives the consumer into debt. Pareto regularly sees consumers “living paycheck to paycheck” with little or no savings set aside to handle emergencies.

“When you’re living like that, you are just on unforeseen accident or event away from complete financial disaster,” says Pareto.

Annalee Leonard, Founder and President of Mainstay Financial Group in Pensacola, Fla., says a solid emergency fund is especially critical during uncertain economic times. A job loss, even for just a month, can devastate a family when they have little funds set aside.

“The economy we live in today is just too unpredictable. You can’t live six months on your credit card. Do that and you’ll be paying it off for 15 years,” says Leonard.

How much money should I have in an emergency fund?

Just how much you should have set aside can vary but most recommendations say somewhere between three and six months worth of post-tax income.

So, if you make $3,000 per month after taxes and deductions for health insurance and retirement contributions, you’ll want to have about $9,000 to $18,000 socked away in your emergency fund.

In general, the less stable and uncertain your income (especially for the self-employed), the more you’ll want to have in your fund.

Pareto says it is also dependent on the number of income earners in the household, the life conditions and various other factors such as whether or not the person has short-term disability coverage.

Because so few people have their targeted numbers set aside, she recommends that you put away money on a regular basis over time to eventually meet that goal.

Something is better than nothing.

Pareto says some who don’t yet have their goal, or may be recovering their account from a previous emergency, may be able to temporarily bridge the gap with a home equity line of credit. These loans can act as an open line of credit by tapping equity in your home.

While you will have to incur debt, and pay an interest charge, they’re certainly much better deals than relying on credit cards. Today’s rates on home equity lines of credit are around 5%.

“That is an option but it does have its drawbacks. And all that assumes that you can even get the home equity line of credit,” says Pareto.

Any emergency fund is also better than no emergency fund. Adam says she has seen people get discouraged, figuring they’ll just throw in the towel if they don’t see it possible to save up three to six months of income.

Adam says to start with what you can and set aside a monthly sum to build as much as you can in your fund. Start with a small savings goal and gradually increase it over time.

Mint.com is encouraging people to set at least one financial goal for 2013 and if you don’t have an emergency fund in place, make that your top priority. And to help you get started, anyone who sets a goal in Mint.com during January of 2013 is entered to win a $500 weekly prize.

Set a goal and start your emergency fund today. No matter how small you start out, something is better than nothing.

What kind of account should I keep my emergency fund in?

While the money should be readily accessible, Pareto recommends that you keep it in its own account to help reduce the temptation to spend it on other things.

The money should not be in your checking account or regular savings account but perhaps in an online savings account that is tied to your regular operating account.

While taking up to two days to transfer the money might seem like a hassle, it can help minimize the chance that you’ll spend your emergency funds on non-emergency expenses.

The emergency fund/debt connection.

Not having a suitable emergency fund often leads people to debt because it is typically the only way they can come up with the money. Leonard says it’s a big problem because it adds interest to the initial emergency and creates a deep financial hole that is hard to crawl out of.

“You’re going to have to put things on a credit card and then you not only have the bill but have to pay 25% interest on that bill. Prepare for things now by saving the money,” says Leonard.

Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor’s Business Daily. He is the author of “Stuff About Money: No BS Financial Advice for Regular People.”