Do you have an emergency fund?

Taking care of yourself and your family involves more than keeping your door locked, letting the dog outside frequently, and setting curfew hours for your children. For some, protection comes in the form of a shotgun or a Rottweiler. But this kind of protection only goes so far. The shotgun, for example, might protect you if you walk in on a robber in the act of cleaning out the silverware drawer, but it won't get you a new heart when your ticker stops ticking (although that gun trick worked pretty well for Denzel Washington in the movie, John Q).

But the point is, no matter what is your preferred manner of watching your back, financial protection should be part of the big picture.

There are many types of insurance, and most of those types are purchased through an insurance broker or arranged for by your employer. But the one type of insurance that you can provide for yourself is an emergency fund.

Do You Have An Emergency Fund?

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Purchased insurance policies cover specific types of emergencies – auto accidents, poor health, damage to property, and even death. With an emergency fund, you name the emergency. The only limit to what your emergency fund can cover is the amount of money you put in the fund. There's no paperwork to fill out, and no one's permission to ask when you want to take the money.

For most people, life goes on, day after day, with very little change. Especially when it comes to finances, there is a routine to which we become accustomed – paychecks at regular intervals for a predictable amount, the same bills repeating each month, allowances for the kids. Occasionally there is an unexpected expense, but we usually find a way to get that paid.

Then an emergency strikes. "Restructuring" at the office means you lose your job, and suddenly that regular paycheck disappears, as does your health insurance, your afternoon trips to Starbucks, and your self-esteem. While you're trying to pull your life back together, who's going to pay the bills? A little rainy day money would come in quite handy.

How much should you save?

Financial analysts suggest a cash reserve of at least three months worth of living expenses, and a reserve of five months of expenses is recommended especially for couples. This emergency reserve doesn't have to be enough money to cover all of your monthly expenses, just the necessities. Money to cover expenses that are optional, such as tickets to events or dining out does not have to be included in your emergency fund.

Warning: Some people intentionally skip creating an emergency fund because they know they have good borrowing power and think they'll just borrow money if they get in a bind. While this may work for some, there are times when a situation, such as a job loss, will negate your borrowing power or your ability to make repayments, and you could be stuck with nothing.

Where should you save it?

There are three characteristics you want to look for when searching for a place to invest the money in your emergency fund.

  1. Little or no risk
  2. Easy access to the money
  3. A chance to earn some money on the investment

The last thing you want to do with your emergency fund money is put it at risk in a speculative investment. The idea behind an emergency fund is that the money is there for you, when you really need it. So find a safe place to put your money, a place where you'll be able to get access to the money on short notice.

Since your emergency money might be sitting idle for some time (ideally you won't have any emergencies and the money can sit idle for a long time!), the money should be invested so that it earns some interest.

A bank savings account is risk free and earns a little interest, although little is the operative word. A step up from a bank savings account is a money market fund. These funds are still completely safe, usually earn more interest than the bank accounts, and you can find money market funds that have check-writing privileges so that you can get your money right away if necessary.

What constitutes an emergency?

When you establish your emergency fund, you should also probably set up some rules regarding how that fund is to be used. If you know you have the emergency money available, it can been quite easy, maybe too easy, to take money out of the fund for situations that may not really qualify as requiring emergency spending.

Only you can decide what constitutes a financial emergency in your life, but if you make the rules in advance, when it comes time to consider drawing money from the emergency fund, it'll be easier to resist using the emergency money for an "emergency" family vacation, or a high-end "emergency" stereo system that just went on sale.

Make a list of all the types of situations you can think of that might require use of emergency money. Examples might include:

  • Loss of a job, either permanently or temporarily (for example, due to a temporary disability) with not enough money available to pay the required living expenses – job loss is the leading reason for use of emergency funds

  • Unanticipated, large, unbudgeted expense, such as the unscheduled need for a new car or a significant home repair, the breakdown of a furnace or major appliance

  • Relative or really close friend gets in financial trouble and needs a short-term loan

  • Necessary but uninsured and unanticipated medical costs, such as psychiatric care after a devastating event, or the need for installation of home improvements due to a disability

    When an emergency situation arises, particularly if there is a job loss involved, there can be additional expenses that you didn't count on, expenses that you don't normally have when you're not in a state of emergency.

    For example:

  • Job-hunting expenses –you might have to spend money on traveling to interviews, creating a resume, printing, postage

  • Benefits –you might have to pay for certain benefits that you were receiving from your employer, in particular health insurance and related medical benefits

  • Education – you might need to acquire additional skills in order to obtain a new position

    Whenever you dip into the emergency fund, whether you deplete the entire fund or just a portion of the money, remember to add an emergency fund item back into your budget so that you begin restocking the fund as soon as the emergency has passed.

    In the days of Leave It To Beaver

    Back in the 1950s, there was a program at many schools called Bank Day. On Bank Day, all of the kids would bring in the spare change they had collected by mowing lawns (standard rate, 50¢) and taking pop bottles to the corner store for the deposit refund (2¢ per bottle). They'd give the money to their teacher who would record the deposit in little savings account passbooks. Somebody from the school would take the money from all the classes to the bank. These nickel and dime deposits would earn a little bit of interest, and in exchange, the children learned a little bit about saving.

    Meanwhile, their parents belonged to Christmas Clubs at their jobs where they turned in a fixed amount each week, throughout the year, then they'd get the money back early in December, plus interest, and that was what they were supposed to spend on presents. It was an easy way of saving so that holiday spending didn't break the budget.
    You don't hear much about those programs anymore, and it's kind of a shame. In the 1950s, saving money was a way of life, just another part of going to school or work.

    This is an excerpt from "Quicken All-in-One Desk Reference for Dummies," by Gail Perry, and was reprinted with permission from Wiley Publishing, Inc.