A Step-by-Step Guide to Creating Your Emergency Fund

by Darren Wu on 18 January 2013 8 comments
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Ask any respected voice in the personal finance community what the number one thing you should do to get your finances in order is, and the chances are very high that they'll say you need to start by developing an emergency fund.

For instance, Dave Ramsey, author of the "The Total Money Makeover," has this as the very first step in his Seven Baby Steps.

Why?

Because if you ever lose your job or are otherwise unable to bring in an income, the emergency fund would be your go-to source until you get back on your feet.

So how do you go about creating your emergency fund? Here's a step-by-step guide to help you. (See also: Emergency Plan: Better Than an Emergency Fund)

Figure Out How Much You Can Save

The first step to creating an emergency fund is to determine how much you can consistently save. Now, if you work a normal job, you probably get paid every two weeks on a Friday. Knowing this, with each pay period, you should be dividing your paycheck between four main categories: retirement savings, fixed costs, regular bills, and savings.

Digging deeper, how much money should you send to each category?

Let's start with your retirement. Most experts suggest saving 10% of your income. That leaves 90% available for your fixed costs, regular bills, and savings. Fixed costs usually include rent/mortgage payments, food, and transportation expenses. Regular bills include utility, phone, and internet bills.

Now, we'll assume you need 85% of your income to pay for fixed costs and regular bills. That leaves 5% available for you to save for your emergency fund.

Knowing these percentages, here's how your money should be divided. Suppose you make $2,000 every pay period. In that case, you'd put $200 towards your retirement, $1,700 for your fixed costs and regular bills, and $100 towards your emergency fund.

Of course, if you look for ways to lower the amount you pay for your fixed costs and regular bills, you'll have more money available to build your emergency fund.

But if you find that your income is barely enough to meet your necessary expenses and you don't have enough to save, you may want to consider getting an extra job on the side.

Set Your Savings Goal

Now that you know how much you can save, the next question to ask yourself is this — how much do you want to save?

Dave Ramsey suggests that $1,000 is a good amount to start with. In our example above, you're saving $100 each pay period, or $200 a month. That means it'll take you five months to create your emergency fund.

Though $1,000 is a good start, most people don't think that's enough. An emergency fund that covers three to six months — or even a year's worth of expenses — has been recommended.

Let's go back to our example above. If your monthly expenses total $3,400 ($1,700 x 2) and you want your emergency fund to protect you for three months, you'll need to save $10,200. By saving $200 each month, this will take 51 months, or four years and three months.

Similarly, if you want ensure that your emergency fund will protect you for six months or a year, it'll take more time. Now after you look at this time horizon, you may get overwhelmed with a feeling of despair.

But don't worry. That's why this last step is the most important.

Automate Your Savings

If you had to manually transfer money out of your checking account and into your emergency fund every month, you'd probably give up after a few months or find excuses to spend your money. Fortunately, there's a better, easier way.

The simplest way to establish your emergency fund is by setting up an online savings account at a bank such as ING Direct or Ally Bank. After you open up an account, you can set up automatic transfers to occur from your checking account. Since the money is out of your checking account, it'll be a bit harder for you to access, so you'll be less tempted to spend it.

Here's an example of how this would work. If you get paid every other Friday, schedule your automatic transfer of $100 to occur on the following Tuesday. That way, in case there are issues with your direct deposit, you have a few days to cancel a transfer. Although this should rarely happen, it's nice to give yourself some wiggle room.

Now you know how to establish your emergency fund step-by-step. By automating your savings, your emergency fund will grow month after month, even while you sleep.

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Guest's picture

I'm slightly confused; when the article says “Most experts suggest saving 10% of your income,” income means the net income / take-home pay, right? I’m already contributing a certain percentage of my gross pay towards my 401(k). Should I also be saving 10% of my net income on top of that percentage? If so, is this where the question of which IRA to choose between comes into play? Or, can I also put my 10% retirement savings in other investments like the stock market or a lazy fund? I might have just answered my own question; I just hadn’t thought of stock investments, mutual funds, or the like as part of my retirement savings. Please let me know if I did indeed figure it out or not! :)

Darren Wu's picture

Hey there, the 10% number is just a rule of thumb. Since you're already contributing to your 401k, then that's a good start.

How much are you contributing to your 401k? If you're putting in 10% of your paycheck there, then you should be in good shape.

Guest's picture

My minimum emergency fund recommendation is save 6 months worth of expenses or the price of a descent used car, whichever is more money.

I figure that the most expensive thing that I own is my car and if it dies I'm basically stuck (public transportation and bicycles aren't going to cut it where I live), so having enough money to replace it immediately in cash is probably wise.

I would also scale the number of months worth of expenses with how volatile your income is. I'm going for one full year's worth of expenses just in case my company doesn't hit some of it's major goals in the next couple of years and then layoffs start.

Darren Wu's picture

Thanks for the insight. I've never thought about having the emergency fund be big enough to pay for a decent car, but you make a valid point.

I also like your idea about increasing the size of your fund if your income is more unstable.

Guest's picture
Bridget

It is all about being disciplined. If you stay focus on a goal, you can make this happen. It isn't fun when you truly have an emergency and don't have the money that can help you.

Darren Wu's picture

You're absolutely right Bridget. It's no fun to be stuck with an emergency bill and have no money to pay it. And automating your savings is a form of discipline that'll help you reach your goal.

Guest's picture

I think automating savings is a really good idea. If you have money going into a savings account for an emergency fund each month automatically, you will begin to think of that money the same way you think of paying bills- non negotiable. This is a great way to build up an emergency fund and really commit to putting that money away for the "what-ifs" in life.

Darren Wu's picture

Great point about making your savings non-negotiable Kelly. Maybe that's where the "pay yourself first" phrase came from - it's a commitment to save before you spend.