Building an Emergency Fund

An emergency fund is just what the name would indicate --

money saved for an emergency, such as a layoff from your job or a major illness in the family. Such a fund should consist of three to six months' gross pay, depending on your situation. If, for example, you are single and have a reasonably secure job, you might be able to get by with three of four months' worth of savings. Conversely, if you have a family, you'll want to have at least six months of savings on hand.

It's also important that your emergency fund is liquid, and retrieving the cash is easy. For this reason, you should keep such a fund either in a savings account at a bank or credit union, or in a money market account. Typically you'll get a better rate of return in a money market account, and your money will remain accessible. In fact, money market accounts limit transactions. This can work in your favor if you're tempted to take the money out for nonemergency reasons. Compare rates and fees, and then open a savings account earmarked for emergencies. In fact, you might even delay investing in your company's 401(k) for a short time to get such a fund started.

The key is to put away a specified amount every month, preferably through direct deposit. In this manner you can aim to put away one month's worth of savings per year, or 8.3 percent of your pay per month. Therefore, if you were making $5,000 per month, you'd put away $415 monthly. After a year you would have $5,000 saved plus some -- although typically not very much -- additional income from the interest.

Avoid the market. The stock market is not the place to keep your emergency fund. You want money that's available in the near future, and the market can be risky in the short term. Mutual funds are also designed for a longer growth period, and like many bonds, are not typically as liquid. While you should certainly be investing your money, the idea of an emergency fund is to have money separate from your investments that you can easily access if needed.

Found money. Another way of building your emergency fund is to earmark a high percentage of your annual bonus for such a fund until you reach six months' worth of savings. A bonus is essentially found money, in that it's not included in your monthly budget. Cash gifts from relatives, a favorable settlement, or even tax refund checks are also good sources of money for your emergency fund.

Keep track of the money you put into your emergency fund, whether in a software program or a notebook, and review your monthly statements to get an idea of how much you have in the account.