NEW YORK (MainStreet) — Financial advisors are big on the idea of building some financial self-insurance, or an emergency fund. But there’s an art to building such a fund, and it goes way beyond popping a few bucks into a savings account.
The idea is to put about six months of your annual income away in a rainy day fund in case of a financial emergency. That could mean the loss of a job, a health issue or some other financial calamity.
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What it doesn’t mean is overspending on a summer vacation, or squandering thousands of dollars in credit card debt. Those are spending issues that require a good debt reduction plan.
Take these steps to a good emergency savings plan:
- Start by getting into the habit. There’s no need to jump in with both feet – you want to drop enough money into your emergency account without causing any financial strife in your budget. Aim for about 5% of your paycheck – 10% if you can really tighten your belt and afford it.
- Opt for a high-yield bank account. The average interest rate for a personal savings account is only 0.173%. But high-yield savings accounts and no-penalty certificates of deposit pay out 2% or more. In the long run, that adds up.
- Set up automatic deductions. Your bank can help you set up an automatic emergency fund. Banks like ING Direct (Stock Quote: ING) will automatically take a percentage of your paycheck and reroute it into your emergency fund. No muss, no fuss.
- Add your emergency fund to your bills. Play a trick on your financial frame of mind by treating your emergency fund like a utility or phone bill – just another bill that has to be paid off every month.
- Keep making “debt” payments. When you finish paying off that car loan or student loan, keep making the payments – but to your emergency fund. If you’ve got a $300 car loan and you’ve paid it off, put that $300 into your rainy day fund. That kind of money accumulates quickly.
- Use a raise or bonus. There’s no law that says you need to spend your raise or bonus from your employer. Instead, take the amount and put it into your emergency fund. It’s money you never had before, so you won’t miss it.
- Use an interest checking account. Banks are starting to offer interest-bearing checking accounts. Most pay more in interest rates than personals savings accounts. Such accounts are easy to plunder, so be careful.
If you keep it up, within six months you’ll have a tidy emergency fund that will come in handy if a financial crisis hits. And if that day comes, you’ll be glad you’re prepared.