How to Establish an Emergency Fund

I'm a big fan of contingency planning. Your ability to effectively manage your money situation falls squarely on your shoulders. Step back for a moment and see yourself as a business. We'll call it "You Incorporated".

As the CEO of You Incorporated, it's your job to run your corporation effectively and plan for the "what ifs" which will inevitability arrive. Now that you've been elevated to CEO, your first job is to start your company on a good solid foundation.

Eliminate your credit card debt, now 
Your first goal is to eliminate all debt, especially credit card debt. The days of paying 10 to 20% to your credit card company is over. Miss a payment and interest rates can reach as high as 31% plus late fees and penalties. If you are paying more than 5% interest on any loan except a mortgage, pay it off immediately.

If you own your own house, a credit line or home equity loan is not an emergency fund. Those are considered loans which you will have to pay back with interest. Don't fall into this trap like millions of others; be smarter.

Given today's economic climate, one should establish an emergency rainy day fund before investing in stocks, bonds or any other assets. Your fund should be based on several factors including job type, industry, age as well as your marital status. A single commissioned sales person should keep more cash on hand than a married couple with no children. You will have unexpected expenses. You will have a rough stretch sometime during your lifetime. Your job as CEO is to be prepared.

How to get started To start your fund, you first need to know how much you're spending in a typical month. Set up an Excel spreadsheet or a notebook and write down everything you spend money on for 60 days. This includes your daily or occasional $  coffee, haircuts, clothes, food, utilities, entertainment; EVERYTHING. Next factor in how much you spend on birthday, Christmas presents and gifts. This includes the occasional office birthday, children, spouse and presents for relatives. You'll be surprised how much you spend in a typical year. When you have determined this number, average this into your monthly expenses and divide by 12. Most importantly, don't forget to add home and car repairs that might occur during the year. You'll have to estimate this amount and factor this into your monthly budget. Now that you've established your monthly expenses, add another 5% for expenses you may have forgotten. This should give you an excellent starting point.

You've now got a basis as to how much you'll need for your emergency fund. As a rule of thumb, you should have 3-12 months of savings. This is only a guide, since each individual situation will vary.

Think of the following scenarios: 
The company I currently work for just closed their doors. I don't have a job and the industry I work in is in decline. What is my first move?"

My company just laid me off. They said they were downsizing. What do I do?

I own my own business. Sales have fallen dramatically. I don't see things improving. What's my next move?

Now picture you have a leaky roof which needs to be replaced immediately. The best quote you've received is $7500. This needs to be done now as some of the wood has started to rot.

You brought your car in an oil change and your mechanic says you need new brakes and two new tires; your total cost; $600.

You're out of work and you or your child has to go see a doctor. With medication, the cost of the visit is $300.

These are all real world situations. They will happen to you eventually and most likely at the worst possible time. How you react and how you prepare for these eventualities of life is your job as CEO of You Incorporated.

Since you've now done your financial homework and now know how much money you spend on a monthly basis. You now need to know where to put your emergency fund.

Here are the places you can secure your available cash: 
Your local FDIC insured bank-Do some more homework and find the highest performing checking or saving accounts in your area. Make sure you ask about any check writing, account maintenance or inactivity   options can also include money market and short term CDs. The function of your emergency cash fund is to have instant access to it. This means you're going to give up earning any chance of a substantial return.

Short Term US Treasury Bills-If you decide to purchase treasury bills, remember you're going to have to factor in commissions. Do not purchase a T-Bill past 6 months in maturity. Should interest rates rise and you need immediate access to your cash, you don't want to be forced to sell at a loss.

Create a CD Ladder 
For sums above $50,000, CDs and money markets accounts still offer the best combination of safety and yield. A good way to invest in a CD is to create a ladder of CDs with maturities that range from 1 and go up to up five years. This will enable you to take advantage of higher rates when you reinvest your shorter-maturity CDs, while still earning higher yields on longer-term CDs.

A little more Risk, a little More Reward

Ginnie Mae funds 
Technically, you can't call Ginnie Mae funds cash substitutes, but they are very close to it. Ginnie Mae funds own packages of home mortgages. These funds kept their value through the financial crisis. That shouldn't come as a surprise because Ginnie Maes are backed by the full faith and credit of the  . Government, making them a much sounder investment than other mortgage-related investments. Check out the Vanguard GNMA fund. This fund did very well last year in 2008, returning a little more than 7%.

If you're not out to find the next  , high flyer or gambling on double digit returns, check out some of the above options. They will keep your emergency fund safer than the roller coaster stock market. 
You've now got a budget in place. You know where to deposit your extra cash. Congratulations! You are now on your way to building your business and getting your financial life in order. 

Larry Lane is the editor for  , a social networking site specializing in personal finance

The article above is information of a general nature and the information provided may not apply to your personal situation. Please consult your financial planner or licensed professional for investment advice.

Larry Lane is the editor for   a social networking site specializing in personal finance. 
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