Get Out of Debt in 9 Steps # 4 – Create an Emergency Fund

The personal savings rate in the U.S. is currently under 1%. Not quite negative territory as we often hear in the media (it was actually only negative for one quarter in 2005), but 1% is clearly not enough. Personally, I never had much more than $100 in a savings account until I started my financial turnaround and saved my basic $1,000 emergency fund. I do have small retirement savings as well, but if I were to look back at the money I have earned in my life versus how much I have now, it’s quite easy to see that my savings rate is less than 1%. We can’t allow this to continue!

If we know that the national savings rate is under 1%, odds are good that you too have very little cash saved for emergencies. Basically, that makes you ‘normal’, but to get out of debt we need to break away from the ‘normal’ American lifestyle.

If you haven’t saved any money yet, saving $1,000 probably seems like a daunting task. It did for me, but once I committed to saving the money it didn’t take very long at all. I started by setting aside $250 and opening an ING Direct Orange Checking account. I started with $250 because I had referral code that earned me a $25 bonus and my referrer received $10 (be sure to ask your friends if they have an ING account and a referral). I like the Orange Checking account because the interest rate is decent and you can use the debit card to handle your emergencies. ING has a very nice online interface as well and I am happy with my choice. You shouldn’t spend too much time worrying about the interest rate on your emergency fund though, you will find that rates vary a lot with the online banks and we aren’t talking about a lot of money in this account (at least not at the start) so just creating an account that you can easily access when you need it is the key.

How much should you save?

Starting with $1,000 is an arbitrary choice, really just a nice round number that will cover most normal emergencies. The rule of thumb is to eventually save 3 – 6 months of living expenses, but that isn’t very realistic for someone just getting started. I will be working on increasing my emergency savings more quickly once my credit card debt is paid off, but until that is done, I’m willing to live with only $1,000.

Ultimately, the amount of your emergency fund needs to be what you are comfortable with. What allows you to sleep well at night? You may need one year of living expenses available in cash. It is entirely up to you, there is nothing wrong with having cash. As your emergency savings grows to larger levels you could safely look at putting some of it to work in CDs or Treasury Bills to earn a little more interest if you wish, but you aren’t going to get much more than a good money market fund if you want to keep your money safe and liquid- which it must be if it is an ’emergency’ fund. Remember, this money is not an investment, it’s a safety net that will allow you to pay the bills if things take an ugly turn in your life. Just think about how you would feel if you lost your job tomorrow. Then think about how you would feel if you lost your job tomorrow and you had $30,000 in the bank. That money really changes everything- you wouldn’t have to rush out and look for a job or take a job that you don’t want just to survive.

It is true that you could have some of your emergency fund invested in mutual funds and most of the time you will earn a far better return on your money. The problem is, you will be at the mercy of the stock market. If your emergency hits when the market is at an all-time low, that $30,000 might only be worth $15,000. You have to decide how much risk you are willing to take, but I strongly advise treating this money as strictly reserved for emergencies and not invested in anything that can go down in value. You will have other dollars to invest so don’t feel like you have to have every dollar in high-yield investments. Remember, it is okay to have cash!

Next up in the series I will cover Living Below Your Means.

9 Steps to Get Out of Debt

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