An emergency fund, also known as a nest egg, is the cornerstone of a sound financial life. It's the cash you keep in a high-interest savings account to cushion financial blows and unexpected life events. That way, you and your personal finances can continue sailing smoothly toward wealth.
Your emergency fund is the financial equivalent of a spare tire--something you need to have and hope to never use.
Typically, experts recommend that an emergency fund cover three to six months of normal living expenses. That's an intimidating amount to save. If you're in financial trouble, start smaller. Aim to put aside $1,000 in a savings account as a starter.
Got Debt? Build a Small Emergency Fund Anyway
Even if you're in debt up to your eyeballs, sock some dollars away in a savings account, even though the interest rate on that debt is higher than even the best savings account rates.
Why does an emergency fund come first? Emergencies happen. During the time it takes you to pay off your debts and curb your spending habits, something unexpected will come up that will cost you money. You'll need to visit a family member far away on short notice, or your car will break down. Maybe your dentist will somberly inform you that you need 14 fillings.
You can't know what it will be. That's why it's an emergency. (Just remember not everything is an emergency. Just like you don't want to ride around on your spare tire for your daily commute, you don't want to tap into your emergency fund to manage your day-to-day expenses.)
If your savings account sits empty while you spend every dollar, you'll have no choice but to put unexpected expenses on your credit card. That gets you back into the cycle of debt spending you're trying to break. When you have even a small emergency fund, you can cushion yourself against those setbacks without taking on more debt.
How to Start (and Manage) an Emergency Fund
To start an emergency fund, first, choose where to keep it. Your emergency fund is not the money that will make you rich. Don't invest it in the stock market or tie it up in a CD or savings bond. You want to access this money quickly in the event of an emergency--but not too quickly. Linking the money to your debit card or checking account can make it dangerously easy to succumb to temptation and spend.
An online savings account is a great choice for building an emergency fund. These accounts may offer a higher interest rate than the savings account options at a local bank. The money is readily accessible but takes a day or two to transfer into your local checking account. That makes impulse spending a little harder, and that's a good thing for your savings.
Also, many online banks make it easy to set up multiple savings accounts targeted for different goals. I use my ING account to manage my emergency fund, my children's education savings, our family vacation fund, and my tax account for my business.
Once you find a high-interest savings account you like, set it up so saving is as easy as possible. If you're paid via direct deposit, split your direct deposit so your monthly savings go straight into that account. It's automatic savings - you never have to see it and won't have a chance to spend it. Doing this with even a few dollars a month is a great habit, and the small sums add up.
You can also commit to adding any "extra" money to your savings account. Windfalls, cash gifts--and the rent check your college roommate owed you for ten years and suddenly made good on--can all go into your shiny new savings account.
Once you've established your emergency fund, you'll have more freedom and security. From there, you can get out of debt, save for a major goal like a house or an education, or put away funds for something fun like a trip to Europe. And you'll do it with peace of mind and good financial habits.