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At LearnVest, we believe your emergency fund should contain at least six months’ worth of net income (up to a year is our recommendation if you have kids or other dependents), and you should only touch it in a true emergency (and no, your family vacation to Hawaii is not a true emergency).
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This is a point that bears repeating: Unless there is a true emergency, it should sit patiently and liquidly in a savings account, waiting for you should you need it (God forbid).
While an ideal emergency fund is at least six months of net income stored in a savings account, it’s best to have upwards of nine months saved if your job is unstable or you work as a freelancer and have an irregular income. Are you in an unstable financial position? If so, aim for nine months to a year.
As I may have mentioned once or twice, the money in this fund is best left untouched unless there is a true emergency. Here are five examples of situations that qualify:
- Emergency 1: You’ve lost your job and need to continue paying rent, bills and other living expenses.
- Emergency 2: You have a medical or dental emergency.
- Emergency 3: Your car breaks down and is your primary form of transportation.
- Emergency 4: You have emergency home expenses. For example, your A/C breaks down in hundred-plus-degree weather, your roof is leaking, your basement is flooded (and no, a kitchen in need of redecorating doesn’t count, no matter how much you hate that wallpaper).
- Emergency 5: You have bereavement-related expenses, like travel costs for a family funeral.
Here’s another reason why you should always have money in a freedom fund: If you don’t, and one of these five types of emergencies arises, you’d likely be stuck using a credit card to handle it, leading you into (or deeper into) credit card debt. In fact, medical expenses are the leading contributor to credit card debt, with low-to moderate-income households averaging $1,678 in credit card debt due to out-of-pocket medical expenses.
Plus, paying for emergency expenses on your credit card (if you don’t pay off your bill immediately) will end up costing you more over time, as you’ll rack up interest payments as you try to dig yourself out of debt. Having a fund will not only save you more money in the long run but also give you peace of mind in knowing you have the safety net to catch those unexpected curveballs when they arrive.
If getting six months of take-home pay together seems daunting, here are eight tricks:
1. Direct Deposit Into Your Savings
This is my personal favorite! Think of yourself as a regular monthly bill you have to pay. All you have to do is arrange to have a set amount of money directly deposited from your paycheck into a savings account each month.
I recommend using a separate savings account because if you have access to your funds in your checking account, you’re more likely to spend them. Again, it might hurt a bit at first to take home a little less every month, but trust me, after a while you won’t even notice it’s gone. Here’s a moment when the “set it and forget it” strategy works wonders.
2. Never Spend a Bonus Again
It feels great to be rewarded for your hard work. And it feels even better to spend that hard-earned bonus on something you’ll enjoy, like a trip to France or an iPad. At the same time, the pleasure of a vacation or new gadget is short-lived compared to financial security. So make a pact with yourself to put every bonus you get from here on out to good use. If you direct 90% of your bonuses straight into your savings account as a rule, you’ll still have 10% to treat yourself with (plus the comfort of knowing that you’re building a well-earned safety net). I live by this rule.
If you get a cash-back reward for any spending on your credit card, just make it a rule that those dollars will be dedicated to your freedom fund.
3. Go Nuts Cutting Your Unnecessary Costs
OK, OK, this seems like an obvious one—and easier said than done. Actually, most people spend money on more unnecessary items than they think. So take time to look at where your money is going in detail and begin to cut back. Saving $10 here and there could help you put a lot away in the long run.
4. Open a Seasonal Savings Account
Many banks offer seasonal accounts meant to save for holidays like Christmas. These accounts give you reduced access to your accounts, charging a hefty penalty each time you withdraw more than permitted. Since emergencies don’t occur often, a seasonal account could make sure you’re touching it only when needed (just make sure you’re not tempted to blow it all on Christmas gifts).
5. Sell Unused Items
I love this one. Chalk it up to my massive craving for organization, but I’m all about getting rid of things I no longer use. Rather than throwing these unused goods away, start selling them, and put that money into your emergency fund. All you need to do is post them to a site like eBay or Craigslist or Amazon and you can get rid of items from the comfort of your home. You can also take your clothes to a consignment shop to have them sold for you.
6. Stop Spending $5 Bills
Instead of saving your pennies, put aside any $5 bills that come your way. Never spend a $5 bill again, and you’ll be surprised by how quickly this silly trick will help you come up with a few hundred dollars to add to an emergency fund.
7. Earn Extra Income
You could pick up odd jobs via websites like TaskRabbit.com, DoMyStuff.com, Elance.com, FreelanceSwitch.com or Sitters.com.
8. Use "Cash Back" Rewards
If you get a cash-back reward for any spending on your credit card, just make it a rule that those dollars will be dedicated to your freedom fund. It may only add up to $100 extra each year, depending on your spending, but every little bit counts.
Reprinted from the book "Financially Fearless: The LearnVest Program for Taking Control of Your Money" by Alexa von Tobel, CFP®. Copyright 2013 by Alexa von Tobel. Published by Crown Business, an imprint of the Crown Publishing Group, a division of Random House LLC, a Penguin Random House Company.