Creating an Emergency Fund

One of the most important steps you can take in getting your personal finances in order is to begin saving money for an emergency fund.

In life, the unexpected happens. Having cash readily available to deal with an emergency can mean the difference between weathering a financial rough spot and finding yourself in debt. An emergency fund is something many people neglect when money is tight, but that is exactly when it should be a top priority. That's when you most need a cushion to deal with the unexpected.

Whether affected by losing a job or a catastrophe such as a fire that destroys a home, a person who doesn't have an emergency fund available to deal with it will almost always go into debt. That can cost hundreds, if not thousands, of extra dollars in interest payments.

How much you need to save for an emergency fund largely depends on your individual circumstances. Even the financial experts disagree on how much you need.

You want a minimum of a couple of thousand dollars. If there is a high demand for your professional services and little chance you will be out of work, you won't need as much in your emergency fund as someone whose career is less secure. Ideally, your emergency fund would allow you to live for three to six months if you lost your job.

Here are five steps to take in order to build an emergency fund:

1. Start now: The most important step is to just begin. Even if money is tight, make building an emergency fund a priority and start putting money aside -- no matter how little -- to build the fund.

2. Separate the account: When you begin to build the emergency fund, make sure to place it in an account by itself and not mix it with your other money. Mixing it with other funds will greatly increase the chance you spend it on other things. You want it to be in a liquid account where you can access the money in a relatively short period of time, but also someplace where it's not easy to see on a daily basis so you aren't tempted to use it for something other than its original purpose.

This makes opening an online bank account specifically for an emergency fund a good idea. The funds will earn a decent interest rate and can be accessed quickly, and an account can be opened with as little as $1 -- and won't require a minimum balance, which is important if the funds need to be withdrawn.

3. Make it automatic: Once you have an account set up for your emergency fund, set a specific amount to be placed into the fund on a monthly basis. If you use direct deposit for your paycheck, set it up so that a specific amount goes to the emergency fund directly after each deposit. This ensures that the fund grows and when you make it automatic, you won't miss the money nearly as much as if you tried to come up with it at the end of the month.

4. Understand its purpose: The money should be used for any unexpected expenses that occur. Obviously, it is not meant for a vacation you want to take or some gadget you want. It also shouldn't be used for things such as insurance bills or property taxes, which you should anticipate and account for in other areas of your budget (but which take many people by surprise since they aren't a monthly expense).

The emergency fund is for expenses you don't expect. For example, you can use it if you get into a car accident and need to pay a $1,000 deductible on your insurance or if you break your arm and have more in medical costs than you normally would have.

5. Use it when you need it: Many people get discouraged when they build their emergency fund and then something unexpected happens and they are forced to use part -- or all -- of it. While the best-case scenario is that you never need to use your emergency fund, it's important to remember the reason you built it in the first place.

If a time comes when you must use part or all of your emergency fund, you should actually congratulate yourself on a job well done. Had you not put it in place, you would likely be in debt over the emergency instead of having to build the fund up again.

Taking the initiative to create and save for an emergency fund today will help ensure that your finances are in much better shape in the years to come.

Jeffrey Strain has been a freelance personal finance writer for the past 10 years helping people save money and get their finances in order. He currently owns and runs SavingAdvice.com.

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