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A key to getting out of debt and on the path to financial success is to avoid using credit cards as a crutch when you don’t have the money to pay off an unexpected expense. Even if you have been working to pay off your credit card debt in a responsible manner, a sudden medical bill or costly automobile repair can run your credit card balance right back up again. One of the best ways to stop this from happening is by setting up an emergency fund to pay for life’s little surprises when they appear.
What is it ?
An emergency fund is exactly what it sounds like. A separate pile of money (i.e., a fund) that you use in the event of an emergency, like an unplanned car or home repair, unexpected medical expenses, and other similar unplanned and frequently unpleasant expenditures. The definition of what an emergency is is up to the individual, but it is important to remember that most things that can be planned for do not constitute an emergency, like regular car maintenance, replacement of appliances that are getting old and functioning poorly that you know will need to be replaced soon, vacations, Christmas shopping, and other expenditures that don’t really constitute a true “emergency”.
Why do I need one?
The main reason you need an emergency fund is that without it, or substantial savings in reserve (which would in effect serve as an emergency fund) it can be very difficult to break the cycle of debt you may be in, especially if an unexpected expense rolls in. If every time you car breaks down, you use a credit card to pay for it, and you don’t pay it off every month, your balances will go up, you start paying interest, and the next thing you know you may be struggling to make the minimum payments. By starting an emergency fund, you are planning ahead for the unexpected, knowing that one day it will happen (which it will).
How much do I need?
If you are deep in debt, you should start with a small amount, say $1000 or so, and then focus all of your extra money you can scrimp together to pay off your debts. I have just passed this point, using $2000 (since I have a family) and now I can focus 100% on paying off the rest of my debt. After you have paid off your debt, most people recommend 3 to 6 months of living expenses as your emergency fund, to protect you from smaller emergencies as well as a job layoff, etc.
Where and how do I start?
If you already have a savings account, it is OK to start there, but many people like to set up a separate account that cannot be accessed quite as easily (like a savings account can be with an ATM card). Online saving accounts such as ING Direct are a great place for this, because the money is not quite as accessible, although you can get it in a couple of days. They also pay higher interest generally, currently around 3.0%. You should begin by putting a certain amount out of your paycheck every two weeks, as much as you can afford, and can set this up automatically as well.
Once you have a “cushion” provided by your emergency fund, you can focus on debt reduction without having to worry as much about the unexpected events of life getting you into as much financial trouble as they once may have.
Reminder- When you take money from your emergency fund, be sure to start putting it back to replenish it right away!
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