So how do you go about protecting yourself with a cushion of money? There are four basic rules that you need to know.
1. Set yourself a goal. I’ve always said that every family should have a cash cushion of at least three months’ worth of expenses. In other words, estimate how much you spend each month on essentials (mortgage or rent, utilities, food, health insurance, etc.), multiply it by three, and that’s your minimum goal for emergency savings. If you typically spend $3,000 a month, you want to have at least $9,000 put away in a reserve account not to be touched unless there’s an emergency. Should you try to save more? Absolutely. How much more depends on what you feel you’ll need to be able “sleep well at night.”
2. Make it automatic. It is so important that you make your emergency fund automatic. That means every single time your paycheck is deposited, your checking account is set up to automatically sweep money into a separate savings account you’ve set up for your rainy-day fund. I suggest you start by moving 5% of each paycheck to your emergency account until you reach the goal you set for yourself above.
3. Put it in the right place. Once you’ve made the commitment to funding a rainy-day account, the next decision you have to make is where to park it. I used to emphasize the importance of finding a place that would give you a reasonable return on your money. But these days, with interest rates at rock-bottom levels and the stability of many financial institutions still in question, I worry more about security. Of course, interest rates won’t stay in the basement forever. But until they recover, which may not be for a long time, I’d focus less on the kind of return you’re getting and more on making sure your emergency money is safe and accessible.
4. Leave it alone. The reason most people don’t have any emergency money in the bank is that they have what they think is an emergency every month. What’s a real emergency? It’s not just having to buy a new dress for that special party. Or deciding you’ve got to get a new dishwasher because the old one is making noise. A real emergency is something that threatens your survival, not just your desire to be comfortable. So unless your family is about to go hungry or be thrown out into the street, you shouldn’t be dipping into your emergency fund.