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Setting Up An Emergency Fund

One of the cornerstones of a solid personal financial plan is setting up an adequate emergency fund and the general advice out there is to contribute as little as 3 months and as much as a year’s worth of monthly expenses. My own personal opinion is that 3 months is probably an adequate amount for an emergency fund for me but then again, I’m willing to accept financial risk (I don’t carry collision or comprehensive coverage [3] as part of my automobile coverage) as long as the savings are high enough.

When you’re deciding on how much to contribute you should look at your personal situation. What’s the purpose of the emergency fund? Is it to help weather a period of unemployment or do you want a fund you can tap into in case you wreck your car or have a medical emergency? Understanding whether it’s a long term disaster you want to prepare for or something more short term will lengthen or shorten the window of emergency coverage you need. If you’re in an industry with a high rate of employee turnover and you’re concerned your job won’t be there in six months, you want to prepare for that by saving as much as a year’s worth of expenses in an emergency fund. If you’re only keeping the fund around in the event of a emergency where your income won’t be affected, six months may be adequate.

The next step is to figure out where you’ll store your money. Ideally you want something liquid like your local savings or checking account, something you can reach as soon as physically possible. Secondly, you might want to consider using an FNBO Direct [4] or ING Direct [5] account too. The principal is protected and you earn around 4% in interest while the money’s in there. You may also opt to go with laddering CDs [6] if you predict you won’t need the money for a few months. For example, if you have 12 months worth of expenses saved up then you can probably ladder it in a way that half the money (the second six months) is earning interest while you’re spending the first six months.

Personally, my emergency fund right now is barely half a month’s expenses because I just raided it to pay off my second mortgage [7]. With credit cards, I have at least a one month grace period in the event there is an emergency (such as the $800 bill to repair mother nature’s wrath [8]) and because I feel that I’m in a low turnover industry so my job is pretty safe. The intent of my fund is to cover major house problems (appliances breaking down?) or unforeseen medical emergencies.