If you learned one lesson during the last several years of sky-high unemployment, I hope it’s that your job is not guaranteed. From high-level executives to hourly employees, millions of people have had the rug pulled out from under them.
Most of these people didn’t have enough money to get them through the rough patch. One recent survey showed that more than half of Americans couldn’t come up with $2000 in a pinch without resorting to desperate measures like pawning their belongings or taking payday loans.
Enter the emergency cushion.
An emergency cushion is exactly what it sounds like: A chunk of money you keep handy in case of an unexpected event. That could be a job loss. It could be a medical expense that isn’t covered by your health insurance. Or maybe it’s a car repair, necessary so you can get to work each day.
The best way to create this cushion is little by little. If you happen to receive a windfall, like a tax return or a bonus, by all means use that to jumpstart your progress. Otherwise, pull as much as you can afford out of each paycheck. Something is better than nothing, but ultimately, you’re aiming to have at least six months worth of living expenses.
Six months of needs, not wants and needs
One thing to keep in mind: Six months of living expenses is not the equivalent of what you’d typically spend over six months. If you were to lose your job, your lifestyle would scale back considerably. You wouldn’t go to dinner on Friday night, or buy new clothes. You’d likely dial down your cable package (or cancel it completely) and put your gym membership on hold. So we’re not looking at six months worth of current living expenses, we’re looking at six months worth of bare bones living. In general it encompasses:
- Rent or mortgage
- Car payment
- Transportation costs (for job hunting, but not commuting, which will save some money here)
- Health insurance (COBRA payment)
- Other insurance (home, auto life)
- Children’s necessities
Park it for liquidity safety, not growth
Where do you put this money? In a savings or money market account that pays a decent rate of interest, but not the same one that houses your vacation savings or the money you’ve been putting away for a down payment on a house. That’s because you want to keep your emergency money separate. If you start blurring the line, your emergency fund could end up paying for that vacation, and all of a sudden, you’re tan but back to square one when it comes to protecting yourself. Open a separate account for this money, and try to get a competitive interest rate while still keeping the money safe and liquid. You need to be able to get at the money whenever you need it, which is why CDs are not as good a home for your emergency cash as money market accounts.