Build an Emergency Fund - Create your own financial safety net

Congratulations! If you've made it this far you're sticking to your budget, out of bad debt and miles ahead of the average American. The hard part is over. Maintain your budget and the good habits you learned along the way. The next step of my 6 step plan will turn you into your own personal bank.

Think about it... how do people get into debt troubles to begin with? Life happens. Roofs collapse, cars crash, people are fired. You can't plan for these things. The only thing you can be sure of is they will happen at the worst possible time. When people are hit with these financial Chuck Norris roundhouse kicks to the face they turn to credit card debt. As you learned in the last step, you pay back triple the amount of money you borrow from a credit card company.

How can you plan for the unexpected? Your next goal is to build an emergency fund. Put 3-6 months of expenses into an account and only use it in case of emergency. Adjust the size based on your personal risk. Use the low end (three months) if you're single with a steady job. Use the high end (six months) if you're the breadwinner for a large family in uncertain times. This isn't your vacation fund or your new car fund. Only use this money when a life emergency happens. Here's the major benefits:

  • You'll never get into credit card debt again.
  • You'll never be tempted to tap into your retirement accounts.
  • You borrow money from yourself, interest free!
  • You have peace of mind knowing you have a financial cushion in case of hard times.
When hard times hit you can rely on this fund until you find a new job or repair damages. When your situation is resolved it's important to treat it like a loan to yourself. Set a repayment plan and automatically deduct money from your monthly paycheck until your emergency fund is paid back.

The last import point is where to park your emergency fund. You never want money sitting in a checking account unless you plan on spending it within the next month. Since you hope to never spend your emergency fund it needs to earn interest. Remember the lesson on inflation in the last step? Money is worth 3% less every year. Think about it, gas cost less than 20 cents in 1950, now it's over $3.00. The same principles apply to your money. If it's not making 3% a year, you're actually losing money.

Most military members bank with USAA (including me). I parked my emergency fund in their "Income Fund" (USAIX). Most of their mutual funds require a $3,000 minimum deposit to open but there's a loophole. You can also open them by setting up a $50 monthly deposit which you can cancel or modify at any time. Stop the transfers once your emergency fund has enough money in it. You can transfer money in and out of this account just like your checking accounts. If you choose to use a different fund make sure it earns at least 3% a year and is low risk. Take a look at the fund history during rough years like 2008 to see how it performs during a bear market.

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