5 Steps to Build an Emergency Fund

A step-by-step guide on how to calculate what you might need in the case of an emergency.
By Morningstar |  06-05-14 | 

You've figured out your goals. You know what they'll cost. So you've put all of your money into your investment portfolio. Then you lose your job. Where will you get money for food and rent? You don't want to dip into that investment portfolio. After all, you've built it with a particular goal and time frame in mind. Touch it now and risk making your future dreams unattainable. That's why it's important to set aside money in an emergency fund before you begin investing.

Here are some pointers for what your emergency fund should cover, how long it should last, and where to put it.

Step 1 – Figure out what to include

We recommend that you cover all conceivable expenses in your emergency fund.

Start with the basics. How much do you spend on groceries each month? If you don't know, now is a good time to start tracking that. And if you eat out a lot, you'll either need to include that, or plan on higher grocery bills. If you have pets, include the cost of their food and care in the tab. Unless you're ready to move into your brother-in-law's basement, be sure to cover your rent payments too.

And don't forget utilities--gas, electricity, water, phone, and even cable/satellite and internet.

Unless you plan on never leaving your house, set money aside for your car payments and public transportation. Of course, you'll also need money for filling up your car, for routine maintenance, and for more serious problems.

Be prepared to meet your insurance payments. That means home, auto, life, and health insurance. Insurance premiums are often the first things to go when money gets tight. They shouldn't be. Set aside money for routine dental and eye care, for prescriptions, and for any other health expenses you may incur.

Step 2 - Estimate what you will need

That's a long list to compile and come up with hard numbers for. The good news is that you don't have to try to brainstorm every conceivable expense. Instead, track what you spend in the next few months and use that as your baseline. Then add in any other possible expenses mentioned above. If you spent money on movies or your gym membership, include that.

Step 3 – How long should it last?

Most financial planners recommend setting aside six months' worth of living expenses in an emergency fund. Be frugal with your spending in case your "emergency" ends up lasting longer than six months. If you take the liberal view of living expenses that we've been taking so far, your emergency kitty likely will last a little longer.

Step 4 - How to get to your targeted amount

Maybe you can cover one or two months' expenses now. Add to that kitty over time. If you get a tax rebate, put it in your emergency fund. A bonus at work? Sock at least part of that away. Dividends from your stock or fund investments? Channelise them here. In general, don't invest elsewhere until you have a full emergency fund.

Step 5 – Where to stack it

Keep your emergency fund separate from your regular bank account. That way, you will hopefully feel less of an urge to tap into it in normal times. But thanks to cash machines and online transfers, you'll still have easy access to the money if you do need it. Don’t keep all the money in a savings account. You could also consider a flexi-deposit that banks offer. This will give you a rate of interest higher than the savings account but provide you with the liquidity. Also park a portion of it in a liquid or short-term debt fund.

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