When it comes to savings accounts, you've probably heard financial advisors and others talk about the importance of having a "rainy day" fund or an emergency fund.
See also: Find extra money to pay off debt.
The point of having a cash cushion, of course, is to lessen the financial blow of dealing with life's unexpected challenges — anything from a car that breaks down to health problems that turn costly.
Even though people use the terms "rainy day" fund and emergency fund interchangeably, these two savings accounts are different in their size, purpose and benefits. So you actually need to have both of these safety nets, in addition to the retirement funds you're currently building.
Here's an explanation of the key differences between a "rainy day" fund and an emergency fund, and some information on how each account can help you and your family.
Size of Accounts
As a general guideline, you should stash away between $500 and $1,500 to have an adequate rainy day fund.
A rainy day fund is smaller than an emergency fund, which typically ranges between $3,000 and $10,000. In fact, some people may need to amass an emergency fund totaling tens of thousands of dollars in order to create proper economic security.
Purpose and Duration of These Funds
The purpose of a rainy day fund is to protect you against unforeseen one-time events, and give you the cash to deal with them without upsetting your monthly budget.
Assume, for example, that you had $1,000 squirreled away in a rainy day fund. That money could cover you in the event your car broke down or your washing machine needed to be replaced. Such scenarios would be a pain to deal with, and economically unpleasant. But these challenges are nonetheless short-term in nature.
By contrast, an emergency fund needs to have enough money to pay your living expenses over a period of three to six months. A healthy emergency fund will tide you over in the event of a major, long-term disruption in your life, such as divorce, job loss, medical illness or injury.
So think for a moment about your normal bills: Are they $2,000 a month, $4,000, far less or far more than these figures?
Whatever your expenses, multiply them times three. Then you'll know how much cash you need for an emergency fund that would last three months. Multiply your monthly bills by six to calculate how much money you'd need for a more prudent six-month emergency fund.
Benefits of Added Savings
Your rainy day fund can help you avoid going into debt or using credit cards excessively to pay for unplanned, short-term expenses. It can also help you avoid resorting to more expensive forms of credit, such as payday loans, that charge ridiculously high interest rates.
Additionally, a rainy day fund affords you the opportunity to practice good fiscal habits — such as delayed gratification and self-restraint — because you must use it only for true emergencies. You won't be able to maintain it if you're constantly engaging in impulse spending or satisfying your wants as opposed to your needs.
Your emergency fund also offers those benefits, plus two additional perks: peace of mind and personal freedom.
If you found yourself suddenly out of work, a hefty emergency fund would give you peace of mind, because you'd be secure in knowing that, despite your economic setback, at least you'd be able to pay your bills.
An emergency fund also gives you the freedom to make personal choices that you can't make when you're cash-strapped. For example, many people build up sizeable emergency funds in order to cover their living expenses once they decide to pursue personal or professional goals, such as going back to school to earn a degree or quitting a job to launch a new business.
Regardless of your financial situation, everyone needs a rainy day fund and an emergency fund. If you have no savings, you should make a commitment to saving money regularly. Over time you'll create both funds that you can depend on when they're needed.
To build up your emergency fund, start with small contributions of perhaps $25 to $50 per month. If you can comfortably afford more — maybe $100 to $200 a month — strive for that in order to more quickly amass the savings you need.
Make the process of saving hassle-free and systematic by having money taken from your paycheck or checking account and deposited automatically into your emergency fund. Saving 10 percent of your salary is a good target. But if you can't meet that goal, even saving 3 to 5 percent of your annual income will be very beneficial.
It's also a smart strategy to use financial windfalls, such as income tax refund checks, to boost your funds.
As you build both your rainy day fund and emergency fund, keep the cash in an interest-bearing savings account or a money market account. You don't want to put this money into a CD or mutual fund because you'll need to have ready access, and you don't want to pay taxes or penalties when you need it.
Next ArticleRead This