When an unexpected bill rears its ugly head, an emergency fund will help you make ends meet without turning to high-interest predatory loans.
When you’re faced with a sudden and unexpected expense, it’s easy to throw your money smarts out the window. When your car won’t start and it’s the only way you can get to work, or your kid breaks her arm and you need to take her to the emergency room, the last thing you want is for concerns about cost to get in the way.
But it’s also a fact that 6 in 10 Americans have less than $500 in savings. Without money in the bank to handle these kinds of emergency expenses, lots of people turn to no credit check loans to make ends meet. And this is especially true for folks who have less than stellar a credit; a payday loan or a title loan might seem like the only way they can afford to pay off those extra bills. Sure, it means paying a lot of extra money in interest, but that’s not what’s important …. Right?
Not exactly. While there are certainly safe, affordable bad credit loans out there, there are others that are, well, not-so-safe and not-at-all-affordable.
And resorting to one of these dangerous loans during a time of crisis can lead to a massive financial hangover that will take you months or even years to get over. A busted car or a kid in the ER are both emergencies, but so is being trapped in a continuous cycle of debt.
The best way to avoid turning to a payday or title loan for emergency expenses is to not need one in the first place. And the best way to do that is to have an emergency fund.
What is an emergency fund?
When you were growing up, did your parents ever talk about saving money “for a rainy day?” Because that’s basically what an emergency fund is. It’s money that you put aside for a time when you really, really need it.
An emergency fund is different from your regular savings. When you’re putting something in your savings, you’re thinking about the long-term. That’s money you’re saving for a down payment on a house, or to put your kid through college, or for your retirement. Funds that you’re putting into “savings” is usually money that you’re sticking in a 401k or other kind of investment account. It’s earning interest and growing over time.
Your emergency fund, on the other hand, should probably be in cash, on a prepaid debit card, or in a basic savings account that you can easily access. It’s not designed to grow your overall “wealth portfolio.” (Sorry, we typed the words “wealth portfolio” and now we’re covered in monocles.) An emergency fund is designed for you to take money out when you need it. The quicker you can get to that money during an emergency, the better.
You know in spy movies or tv shows where operatives will have a “go bag” filled with money and passports and tactical gadgets that they can grab instantly and disappear into a crowd? Think about it like that. (Especially if you’re having a hard time getting excited about it. An emergency fund sounds boring. But a financial “go bag?” Heck yeah.)
How much money do you need in your emergency fund?
“Listening to experts on this topic is like owning a Cadillac, a Honda, and a Kia,” says Howard Dvorkin, CPA and Chairman of Debt.com. “You’ll get different mileage even while you head to the same destination.”
Think about the different kinds of financial emergencies in your life. Repairs to your car could run you a few hundred dollars, while a surprise hospital visit—even with insurance—could run you a couple thousand. And what about losing a job? Depending on how long you’re out of work and how expensive your lifestyle is, you could be looking at tens of thousands of dollars in bills that would need to be covered.
“Some experts insist you need a year’s worth of expenses in an emergency fund,” says Dvorkin. “Others say three months or six months. I say even a week is progress. I never want to give a hard number, because that might discourage people from even starting.”
Start with an achievable goal, like $1,000. Save up $1,000 and stick it in a safe or in a sock drawer with a “No Trespassing” sign hanging from the knob. Once you have that $1,000 saved, you can start working towards a higher goal. As long as you’re putting money away on a regular basis, you’re doing well.
What’s the best way to build an emergency fund?
There is no “right way” to save, just like there’s no “right way” to eat an Oreo. It’s all about doing what works best for you.
However, there are some basic principles that apply to any savings strategy:
- Have a Plan. If you want to get serious about saving, then you can’t just “figure it out as you go.” You need to make a plan and then you need to stick to it.
- Be Consistent. When you’re creating your savings plan, you should avoid saying stuff like “I’ll just save whatever I have left over at the end of the week.” Decide on a specific amount that you’ll save every week, every month, or even every day!
- Pay Yourself First. This goes back to the idea that you shouldn’t put aside “whatever money is left over.” Make building this emergency fund a priority. Decide the amount you want to put away and then build the rest of your budget around that.
Okay so maybe we lied. There is definitely a “right way” to save.
Here’s what Dvorkin has to say on the subject:
“Saving is like dieting. If you don’t make it part of your lifestyle, you’ll eventually cheat and fail. So saving on a regular basis means saving very little all the time, instead of a lot every paycheck. We’re talking one more brown bag lunch, and those few bucks going into a savings account.”
Saving a little bit all the time is a great strategy for another reason as well: If you end up cheating and splurging on something you don’t need, it’s not a big deal. Saving small means failing small. And failing small makes it all the easier for you to get back on the horse and keep going.
One more piece of advice: As you’re creating your savings strategy, take a good long look at your monthly budget. Maybe, as you try and save for six months’ or a year’s worth of expenses, you’ll notice places where you can cut back. It’ll give you more money to save all the while making your eventual goals more achievable!
Is it wise to build an emergency fund if you’re in debt?
Yes, it is. Paying down debt is super important to your financial wellbeing—not in the least because it will help raise your credit score—but not having an emergency fund means you’re leaving the door open for future debt.
Still, it’s not like you should stop all your debt repayment efforts to build an emergency fund. Doing so is going to cost you a lot of money in the long run.
“Paying off debt is more important, purely for the numbers,” says Dvorkin. “You’ll earn only one percent interest on your savings—if you’re lucky. Meanwhile, your credit cards are charging you 16 percent and up.”
Really, it’s a matter of balance. Don’t let building your emergency fund set you too far back in paying off your personal loans and credit cards, and don’t let zeroing out your debt leave you with no money to put towards savings.
Besides, the kinds of discipline that building an emergency fund requires of you might come in handy with debt repayment as well. Dvorkin likes to say that “Saving when you’re in debt might seem like drinking bottled water when the boat you’re in is sinking.”
“But if you save small amounts constantly,” he adds, “it might also help you focus on paying down your debts.”
When should you start building your emergency fund?
“If you don’t have an emergency fund right now, you’re running behind schedule,” says Dvorkin. “Everyone who’s graduated from high school needs one, because everyone can suffer an accident or an illness.”
You heard the man! Start building your emergency fund right now. Seriously. Reach into your wallet, grab a dollar, and shove it under your mattress. Congratulations, you now have an emergency fund.
That wasn’t so hard, was it? Now all you need to do is keep going!
Howard S. Dvorkin (@HowardDvorkin) is a two-time author, personal finance expert, community service champion and Chairman of Debt.com. As one of the most highly regarded debt and credit expert in the United States and has played an instrumental role in drafting both State and Federal Legislation. Howard’s latest book “Power Up: Taking Charge of Your Financial Destiny” provides consumers with the detailed tools that they need to live debt free and regain their financial freedom. Howard has appeared as a finance expert on CBS Nightly News, ABC World News Tonight, The Early Show, Fox News, and CNN.
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