If you’ve read any personal finance advice or even watched Oprah for any length of time, you’ve heard of the emergency fund. It goes like this: you need to have at least three to six months worth of living expenses in cash in case a true emergency arises. I can hear you already “Three to six months? Who are they kidding?”

That was exactly my attitude, too, until I thought about it. Now I see the light. I’ll admit that right now my husband and I are focused on paying down debt, so we’re not contributing to an emergency fund, but it’s next on our priority list after the debt is gone.

If you don’t have an emergency fund, consider opening one now. With all the chatter about a possible recession and ongoing cutbacks due to the credit crunch, anyone in an industry on the bubble should contribute as much as possible while you still have a job. Even if you think your job is safe, you should have something because you never know when you could lose your job. The more specialized your field, the more money you should set aside because your job search will be longer. Elementary school teachers can find work quickly. Rocket scientists can’t. Where do you fall in that range?

How Much Do You Need?
Most advisors say three to six months of basic living expenses in cash. The key is “living expenses”. That means the following:

  • Housing
  • Utilities (telephone, water, gas, and electric)
  • Fuel
  • Food
  • Primary and secondary school tuition
  • Medical/dental expenses
  • Car payments
  • Child support/alimony

These are expenses you must pay every month. Other bills, like student loans, can often be deferred. Credit card issuers are more than happy to accept minimum payments. Some may also defer payments temporarily. You’ll notice that cable isn’t a basic expense. If you can’t afford it, cancel it in an extended emergency. You can always resubscribe later.

So, if you spend $10,000 a month, look carefully at how much you actually you need to spend. It could be around $5-6,000 once you get down to absolute necessities. That’s much more attainable for most people.

How to Save for an Emergency Fund
If you’re scraping your pennies to pay everyday expenses, it’s tough to find room for an emergency fund. But you may be able to put $50 per paycheck (that’s $100 a month for bi-weekly payroll, $200 a month for couples) into savings. It doesn’t seem like a lot, but after a year, that’s $1200-$2400. It’s not enough to cover three to six months, but it’s a small cushion. If you don’t have credit card debt, you can probably find more money. Don’t avoid contributing to your retirement account, though. You can recover from a financial emergency. Not having money for retirement could be direr.

In addition to finding the money, you can also put any “found money” into the emergency fund until it’s fully funded. I include the following in the “found money” category:

  • Tax refunds (unless you’ve adjusted your withholding, in which case use the money you’re no longer having withheld)
  • Inheritances
  • Financial gifts
  • Class action settlements
  • Bonuses

If you contribute all of those, even if they’re small, they’ll add up over time.

Where to Keep an Emergency Fund
You don’t want to keep an emergency fund with your other money, otherwise you’ll be tempted to use it. It should also be in a liquid position. Some people recommend keeping it in a CD, but CDs are locked, which isn’t really liquid. I prefer a savings account with a good yield. ING Direct and HSBC Direct both have good interest rates on their online savings accounts, both are FDIC insured, and both are from banks with solid histories.

Ideally, you should be able to transfer money to your checking account when you need it, and be able to easily make deposits, but you don’t want it convenient enough that you can withdraw $20 here and $40 there to cover that “emergency shoe purchase.” Unless your house burned down and took every single pair of shoes with it, shoes are not an emergency.

What Constitutes an Emergency
This fund should be for true emergencies. Here’s how I define that:

  • Job loss
  • Serious illness
  • Major natural disaster
  • Major personal disaster
  • Emergency home repair
  • Major emergency auto repair

Notice that all of these are serious events. If you’ve lost your job, tap that emergency fund to avoid going into debt during your search. When I was a teenager, my dad was laid off. He used the college savings account (this was before the days of 529 plans) to pay the mortgage and grocery bills while he looked for work.

I know two people who had heart attacks and used all of their emergency funds to cover medical bills and living expenses while they recovered.

I live in earthquake country, which means I could lose everything at any moment. That’s one reason I want to keep my emergency fund online – I can access it from anywhere in the world. In a natural disaster, my local bank branches could be closed for several days.

I don’t own a home, but I would consider fires, sudden roof leaks, or home floods to be emergencies. Your insurance might cover it, but it’s good to have some money on hand until insurance pays up.

By emergency auto repair, I mean things like a new transmission for your primary car, not your standard oil change.

Emergency Fund Alternatives
If you own a home, you can use a HELOC to supplement your emergency fund. If you don’t own a home, keep a low-rate credit card somewhere safe so you can tap it if necessary. It’s best to have cash, but other alternatives are good if you don’t want to keep a lot of cash in a low rate account or haven’t yet built up a sizable reserve. In an extended emergency, they can also prevent you from running up much higher credit card debt that will take years to pay off.

If you’re single, you might not need a large emergency fund, but if anyone else is counting on you, start your savings as soon as possible. In this world, you never know when you’ll need it.

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