It’s easy to get blindsided by the disasters or unexpected expenses life throws at you. I’m talking about things like car accidents, medical emergencies, getting laid off or even spilling coffee on your laptop.
That’s why I created a “Stupid Mistakes Fund” to hedge against financial disasters. This is an emergency fund I use for dumb mistakes and money pitfalls.
If you’re like the majority of Americans, you’re likely not financially prepared when those things happen. So when they do occur, you’re going to be looking at a hefty bill with no good way to pay it.
That’s why you need to build an emergency fund. This is a pool of money set aside for things like:
- Medical bills
- Auto repair
- House repair
- Economic downturns
- Job loss
- Financial theft
Once you have it, you’ll have the peace-of-mind knowing you’re ready for most all financial hardships.
To create one, you just need to do three things.
Step 1: Determine the amount you need
A good rule of thumb is to set aside enough money for three to six months of expenses. If you lose your income, you’re going to have to keep yourself and/or your family afloat while you find a job. That’s why three to six months of expenses is a good benchmark.
That includes things like:
- Mortgage payments
- Car payments
- Utility bills
Add all of these expenses up to figure out roughly how much you need for your emergency fund. It doesn’t have to be perfect. A ballpark estimate is a good place to start.
For example, if you find that you need $1,000 a month to get by, your emergency fund should be around $3,000 to $6,000.
Tip: If $3,000 was your goal, and you were putting away $500 toward building your fund, it’d take you six months to get there.
That’s not very long, and you’ll be better positioned for financial hardship than the majority of your peers.
The best part: You can start building your emergency fund passively with a simple system — which brings us to …
Step 2: Open a sub-savings account
An emergency fund is just a collection of money set aside for an emergency. You can put it into a checking account, savings account or in a shoebox under your bed (I do NOT suggest this).
My advice: Use a sub-savings account.
Sub-savings accounts are smaller accounts you have along with your regular savings account. You can use them for specific savings goals like a down payment for a house, your wedding, or vacations. You can even give your account a nickname to reflect your savings goals.
Using a sub-savings account gives you a huge psychological benefit. When you deposit your money into specific accounts for your goals, you’re going to be much more likely to achieve them.
Call your bank and ask if they offer them. Chances are they do. However, if you need some suggestions for banks with sub-savings accounts, here are my suggestions:
- Capital One 360 / ING Direct (This is the one I use)
- Ally Bank
Create a sub-savings account labeled “Emergency Fund.” When you have it, you can start to automate your earnings to flow into that account.
Step 3: Automate your system
Automating your finances is a great way to make your money work for you. This system allows you to invest and save without manually moving your money around. When you get your paycheck at the beginning of the month, your money goes to exactly where it needs to go automatically.
And it’s simple: Spend just an hour calling your utilities and credit card companies, and ask them to bill you at the beginning of the month (or whenever you receive your paycheck).
When that day hits, your money is going to flow from your checking account to these areas.
You can set it up so that a portion of your income goes into your emergency fund as well. To start, I suggest putting 5 percent of your monthly take-home pay into the fund.
Once you have your system automated, congratulations! You’re now on your way to having an emergency fund and ensuring your financial security.
4 tips for your emergency fund
Once you have your fund, here are four things you should keep in mind:
- Tighten your belt. If you lose your income and have to dip into your emergency fund, you’re likely going to have to make some sacrifices to save more money — at least for the time being. That means no more fancy dinners, expensive Broadway shows and putting down payments on new Teslas. Of course, you don’t have to do this as long as you factor it into your savings goals.
- Take a look at two years of your spending. If you take stock of how much you spent for emergencies in the last two years, you’ll find that a lot of your financial emergencies are predictable. For example, I discovered I had two speeding tickets over two years, so I accounted that into my fund.
- Start at $100. By the end of the year, if you made a financial mistake or encountered an emergency, you have $1,200 to spend on it. If not, then you can …
- Treat yourself. If you haven’t dipped into the fund all year, feel free to take a portion or even all of that money and spend it on something you like. Consider it a reward for not making any dumb financial mistakes all year.
Follow those tips, and you’ll be ready for most all emergencies.
Ramit Sethi is the author of the New York Times bestseller, I Will Teach You To Be Rich. For more tips on investing, check out I Will Teach You to Be Rich, where he writes about money and psychology.
MORE FROM BETTER
- How to budget (and get out of debt) if you live paycheck-to-paycheck
- How to negotiate anything, according to neuroscience
- Smart money moves to make now to improve your finances in 2019