Your most important account

We’re going to take that concept of “pay yourself first” and apply it to, what many financial experts consider, your most important account: the emergency fund.

The emergency fund

Having a backup source of funding for emergencies will not only let you sleep peacefully at night, but it will also help you start improving your financial life. By keeping some money aside for the unexpected, you won’t have to borrow against your credit cards or worry about when your next paycheck is coming in.

Keep in mind that this fund should be used for emergencies – things like a crucial car repair, hospital bills, or staying afloat after a job loss. This money should not be used to buy a new iPhone or Coach bag.

Handling the details

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Different experts will recommend different amounts for the size of your emergency fund. One general rule of thumb is to put away about 3 months worth of your pre-tax salary. That should be good enough for you to survive for a while if you lose your job, or for handling any major expenses that aren’t covered by insurance.

Ideally, you’d be able to put away all of the money for your emergency fund right away. If this isn’t feasible for you, you can “pay yourself first” by taking a small amount from your paychecks and transferring it into your emergency fund. You can even set up your accounts to make the transfer automatically, though I wouldn’t recommend that because once you’ve built up your emergency fund, you’ll no longer need to continue the transfers.

You may want to consider keeping your emergency fund in a money market account. These types of accounts are considered “safe” investments that are designed to protect your initial investment and give you a small rate of return on your deposit over a long period of time (which is how long your emergency fund should last). It’s true that in this past recession, some mutual funds lost a small percentage of their value because the fund managers decided to invest in relatively risky assets. In order to avoid this, you should compare money market offerings from the major financial institutions and choose only those that provide some sort of description of their assets, or a guarantee that they invest in only solid, stable assets. Keep in mind that a money market account is still an investment, and is subject to risk, but it’s very unlikely. Some of the best money market accounts are online only, ING and HSBC Direct are two good examples.

In the past, money market accounts could give you a nice return of about 5% per year on your deposits. But since the “Great Recession”, those rates have dropped to 1-2%. That is a fairly low yield, and you could do better with government bonds, treasuries, and CDs, but each of those comes with restrictions on when you can withdraw your money. Money market accounts are a bit nicer because they provide the flexibility of being able to easily transfer money and write checks against your balance. In theory, once the economy recovers, the yield on a typical money market account should be higher.

At this point, you should be able to see how having an emergency fund can act as a safety net for unexpected expenditures. In the next article, we’ll discuss how to manage your main checking account.