Wednesday, January 3, 2007

Emergency fund

Now what exactly is an Emergency fund? Its some money put aside to be used only during emergencies. That leaves us with 3 questions
  1. How much money do you put aside for an emergency fund?
    I recommed money worth 12 months of a person's expenses. So, if a person earns $1500/month & spends $1000/month, he should have 1000 * 12 = $12000 worth emergency fund.

    Some people might argue that this is a little too much but I think 12 months worth money is a safe margin. Lets face it, shit happens. We could lose our jobs, our business could be in trouble, you or your loved one could be in a serious medical condition.

    I think till a person has 6 months worth expenses in the Emergency fund, he should refrain himself from investing (apart from investing in 401K & IRA). After 6 months, he should invest a major portion towards the Emergency fund & little towards buying stocks and mutual funds. The final goal should be 12 months worth expenses.

    Once a person accumulates 12 months worth money in the Emergency fund, he still needs to keep a watch on the fund. The reason is a persons monthly expenses does not stay the same forever. He can move to a more expensive city, have a spouse and kids, have a bigger house. So, when the monthly expenses increase, he should increase his contribution to the emergency fund
  2. Where do you put this money?
    You should put this money in a savings account that pays high interest, something like HSBC Direct, ING Direct or Emigrant Direct. I use HSBC Direct and I am pretty satisfied with it. Anything that gives you 5% or more is a good option. These online banks are good because they give you a good interest rate plus its easy to withdraw money
  3. Should you use this money only during emergencies?
    Ideally, yes! As far as possible use only during emergencies. If a down payment for a car or house means an emergency to you, you may use it; thats a personal decision. But I would suggest to start another account for a house/car down payment and leave the Emergency fund as it is!

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