Building an emergency fund(EF) is one of the first steps you can take in order to get your financial life headed on the right path. Whether you’re just starting to pay your own way, or 5 years into your career, financial emergencies can happen at any time. Medical expenses, getting laid off and even minor car repairs can seriously damage your finances if not adequately prepared. An emergency fund will help you absorb these one-time costs without going into debt.
With that being said, each situation is unique and requires a customized approach. The first step you should take is to save $1,000; this should cover any type of minor emergency. Now it’s time to pay off any debt you may have.
Paying off Debt
It’s pretty easy to figure out which type of debt is having the largest effect on your wallet. Any type of high interest credit card or auto loan debt should be paid off immediately.(A line of credit should not be used as an emergency fund!) It’s very difficult to make headway in paying off debt and saving for an emergency fund at the same time. So once you have your debt under control, it’s back to building that emergency fund. I try to keep about 6 months worth of expenses in my EF. Most of you in the early stages of your career should feel comfortable with 3-6 months.
What to do with the money?
Since we need the money to be liquid and accessible, there are only a few safe investment options for our EF. With savings rates at an all time low, I recommend taking advantage of a strategy known as a CD ladder. There are a couple different methods, but most have the same basic principals. A CD ladder staggers your certificates in a sequence of 3 months, 6 months, 9 months, 12 months. As one CD matures, it is rolled into a new ladder.
Emergency Fund: $10,000
Every 3 months, you would purchase a 1 year CD in the amount of $2,500.
Your purchase dates would be Jan. 1, April 1, July 1 and October 1.
When our first CD matures, we roll it into another 1 year certificate and continue building the ladder. We now gain the higher interest rate assigned to CD’s while keeping our money liquid. Most emergencies will not require the entire emergency fund, so we will only need to break one rung of the ladder to access our money. The penalties for terminating a CD are different for every bank, but generally never exceed one to three month’s accrued interest. The CD’s will return interest to the principal and renew every year in order to maximize your money.
Some Current CD Rates(as of 2/2/2012)
Ally Bank 1 year CD: 0.99%
ING Direct 1 year CD: 0.50%
Bank of America 1 year CD: 0.45%
Make Sense? How much do you have saved in your EF? Do you think it’s more important to have a larger EF before paying off debt? Let me know what you think..
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– PF pro