Start an Emergency Fund to Prepare for Financial Emergencies

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Hurricane Sandy isn’t just a natural disaster; it’s a financial disaster, too. Current estimates predict the superstorm will ultimately cost the country tens of billions of dollars. But that big, big number represents its total damage to the nation. What matters more is how much financial damage the storm does to you.

When disaster strikes, many people count on insurance to bail them out. Insurance is important, no question, but it’s also important to remember that nobody cares more about your money than you do. Ultimately, you are responsible for protecting your family’s financial well-being. One of the best ways to do this is through self-insurance, by building a substantial emergency fund.

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An emergency fund — or “rainy-day account” or “safe and sound money” or whatever you’d like to call it — is a chunk of change set aside specifically for the unexpected things life throws your way. It’s not to be used to buy a new car. It’s not to be used for a vacation to Paris. It’s not to be used to remodel your bathroom. It’s for use only in case of emergency: a tree falls on your house, your youngest daughter breaks her arm, you lose your job.

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Though personal finance experts agree emergency funds are necessary, there’s no consensus on how much is enough. Liz Weston, for instance, has argued that for many people a zero-dollar emergency fund makes sense. (Instead, she says, emergencies can be handled by credit card.) Others, such as Suze Orman, advocate stashing aside up to eight months of living expenses.

My own advice is to do what works for you. Start small. If you don’t currently have a rainy-day fund, then something is better than nothing. Set aside $500. Or $100. Or $20. Over time, work to build this buffer until you have $1000 or $5000 on hand for catastrophe. Ultimately, you’ll sleep more soundly if you do have six to twelve months of living expenses in the bank. It’s a comfort to know that if you lose your job, you won’t lose your home right away.

Here are the basics on starting an emergency fund:

    • Pick a bank. I’m a fan of local credit unions and community banks, but I also like high-yield savings accounts at online banks. (My emergency fund is at ING Direct, though there are plenty of other options.)
    • Build a buffer. If you’re still in debt, it’s probably best not to stick a lot in savings. You should set aside $500 or $1000 to deal with annoying emergencies like a car that breaks down, but the rest of your money should be thrown at your debt.
    • Resist temptation. When you have a big chunk of change sitting in the bank unused, it can be tempting to use it for other things. Resist the urge. Use your emergency fund only for emergencies, otherwise you defeat the purpose.
    • Save more. As your debt dwindles, and as you get better control of your finances, build your emergency fund. Pick a number that helps you sleep at night. For me, that number is $10,000. That seems like a lot of money to me, and if anything disastrous happened, it would help me survive for a long time.

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Finally, it’s wise to keep your emergency money someplace that’s not too easy to access. (Ignore this piece of advice if you know you’re disciplined enough not to use the money for other purposes.) You might, for example, open an account at a bank across town. Or deposit the money with an internet bank. Or put the money into a certificate of deposit. Don’t carry a debit card tied to the account. You’ll still have access to the cash when you need it, but you’ll be forced to consider your actions before making a withdrawal.

From experience, I know that it can sometimes be painful to see a large pool of money sitting unused for months (or years) on end. But also from experience, I know that when a natural disaster strikes (or any other kind of disaster, for that matter), an emergency fund goes a long way to preventing financial disaster as well.