Many new professionals are eager to start paying off their student loans early and investing extra heavily into their company 401k. Unfortunately, the most common financial trap you may be falling into is if you’ve not first established a well-funded emergency account, then you could be handicapped severely in the future and left without any safe outs.
An emergency fund is an account that you do not dip into except in the case of an emergency. If you don’t have an emergency fund, you should. Emergency funds can keep you financially afloat when unexpected events occur – like loss of job, natural disaster, sudden illness, or severe home or car troubles. Which almost inevitably will happen to you sometime in the next few years and when it does, you could set your finances back years if you haven’t properly prepared.
Ideally, an emergency fund should contain at least 6-9 months worth of your household’s living expenses. This number will need to take into account monthly utility bills, groceries, fuel, insurance payments, mortgage or rent payments, minimum credit card payments, and any other expenses that are regular, budgeted expenses. This number may be larger if you have dependents, have an upscale lifestyle, or maintain heavy debt. 6-9 months worth of living expenses will cover you and your family in the event of a job layoff or sudden and severe illness that prevents you from working.
Alternatively, or in addition to the above-mentioned expenses, if you foresee having to increase your expenditures in the near future, your emergency fund should also take these considerations into account. If your mortgage will require you to make balloon payments, if your car has been running poorly for some time and you expect to have to purchase a new vehicle soon, or if your roof has been showing signs of wear, your emergency fund should contain enough money so that you will be able to maintain normal or only slightly reduced quality of living while making sure that your needs are being met.
An emergency fund should not be used as an entertainment fund. It is for emergencies only. Emergencies are not the latest electronic devices or new wardrobes. Emergencies may include a new computer if your income relies upon it, or even a vacation if your mental or physical health is being compromised due to extreme stress and over work.
You should keep your emergency fund in an account to which you regularly contribute; most banks can set up an automatic deposit system. The emergency fund should also be in an account that is not readily available, but that can be easily accessed when events necessitate. And finally, there are many high-yield savings accounts available that will help that nest egg earn some cash while it waits to be called on. We recommend checking out this resource for a good list of options to evaluate. High Yield Savings Rates by Bankrate.com
If possible, do not think about the money in your emergency fund, except to calculate how much money it should hold. This will help prevent you from seeing it as “extra” cash that can be spent when you want something that is not a result of an emergency. Pretend the emergency fund doesn’t exist unless you are making contributions to it. Only then can you be sure that you and your family will be covered in the case of unexpected and unfortunate events.
Once you have your emergency fund well established, then it’s an appropriate time to begin considering the next best use of your income surplus whether that be paying off student loans or investing toward your retirement.