How to make sure you have enough money for an emergency, in 3 simple steps
"No matter how well you plan or how positively you think, there are always things out of your control that can go wrong," writes David Bach in his bestseller, "The Automatic Millionaire."
"People lose their jobs, their health, their spouses. The economy can go sour, the stock market can drop, businesses can go bankrupt. Circumstances change. If there's anything you can count on, it's that life is filled with unexpected changes."
The best way to prepare for life happening is to create a cash cushion, which Bach outlines in three, simple steps:
1. Decide how much you need.
The amount of savings you need is highly personal, so it isn't usually measured in terms of dollars. Rather, it's months of living expenses that money could cover.
Bach suggests having at least three months' worth of expenses: "Take what you estimate you spend each month, multiply it by three, and you've calculated your goal for emergency savings," he writes. You'll want to include costs like your child's tuition, any debt payments you need to make, or any other expenses you'd have to cover if your income is interrupted. "Three months' worth is a great starting place, but if you want to go higher, by all means do what feels right to you."
Many experts, including billionaire John Paul DeJoria, agree that it's smart to have six months' worth of savings tucked away. You may personally need more or less depending on your situation.
2. Don't touch it.
Your emergency fund is for a real emergency - a medical emergency, a death in the family, or to cover your living expenses should you lose your job and income.
"The reason most people don't have any emergency money in the bank is that they have what they think is an emergency every month," writes Bach. "What's a real emergency? Be honest with yourself. You know what a real emergency is. A real emergency is something that threatens your survival, not just your desire to be comfortable."
3. Put it in the right place.
You'll want to earn interest on the money you set aside for a rainy day, which means you'll most likely want to avoid putting it in savings and checking accounts.
"Most savings and checking accounts pay little if any interest," explains Bach. The "big banks" out there - Bank of America, Chase, Citibank, and Wells Fargo, to name a few - usually offer an interest rate of 0.01%, meaning your savings just sit there, growing by a negligible amount.
However, your savings still need to be accessible when you need them. Bach recommends a money market account: "When you make a deposit in a money market account, you are actually buying shares in a money market fund - a mutual fund that invests in the safest and most liquid securities there are." Instead of earning an interest rate of 0.01% like you would with the typical savings and checking account, you could earn an interest rate of 1%. That's 100 times more interest on your money. Start by looking at NerdWallet's list of the best online money market accounts.
Another option is to use a high interest savings account at an internet bank, such as Ally Financial or Synchrony Bank, which offer interest rates up to 1.25%. Magnify Money lists some good options, and allows you to compare how much you would would save with a high-interest account compared to a savings account offering a rate of 0.01%.
Another bonus of moving your emergency savings to a separate account: You draw a mental and logistical barrier between this money and your other savings, so you don't accidentally blow it on a trip to the Bahamas.