Emergency Fund

"I'm tapped out, Marv. American Express has got a hit man looking for me."
--Bud Fox (Wall Street)

An early step toward financial independence involves establishing an emergency fund. An emergency fund is cash savings that can be used to pay expenses in the event that either a) you have no income (e.g., temporarily unemployed) and must pay routine expenses such as mortgage, rent, utilities, insurance, entertainment, etc, or b) you are subject to a large, unusual expense that your regular income can not easily fund (e.g., big car repair, medical expense).

It is commonly proposed rule that an emergency fund should be large enough to cover six months of living expenses. Personally, I would recommend more than that--a year's worth of expenses is a better target.

To determine how large your emergency fund needs to be, you first need to estimate your expenses. I recommend estimating expenses on a monthly basis for an entire year. An easy way to do this is to make a spreadsheet. Put months JAN thru DEC in the rows. In the columns, put various categories of expenses (school payments, clothes, entertainment, transportation, insurance, etc). When you are young, you won't have many expense categories but it is a good habit to begin tracking them.

Once your spreadsheet is set up, forecast your expenditures for each month throughout the year. If you think you'll spend $100 for clothes this month, then put that estimate in the appropriate cell. Sum up your expenses each month, and then sum the months to get an annual estimate of expenses. That number serves as the initial target for your emergency fund.

As the year unfolds and you pay actual bills, replace the estimates on your spreadsheet with the actual amount you spent. If you actually spent $121 on clothes this month, then revise accordlingly. On my spreadsheet, I boldface actual expenses to distinguish them from my forecasts. Over the course of the year, you'll get a better idea of what you actually spend, and that bottom line number for annual expenses will become a more accurate target for your emergency fund.

The other thing you have to do, of course, is save money to build your emergency fund. Put your savings in accounts where you can easily access cash to pay bills if you have to. Although it would be nice to earn as much interest on these savings as possible, the priorities here are safety and ease of access. If you have to sacrifice some returns in order to ensure liquidity, then do so.

Be patient. Emergency funds are not completed overnight, especially when you're just starting out. Over time, though, tracking your expenses and building savings to fund life's expenses will put you in better control of your financial future.