5 steps to building an emergency fund

By Joe Light, Money Magazine staff reporter

(Money Magazine) -- Lindsay and Patrick Heineke seem to be doing everything right, financially speaking. The Whitinsville, Mass. couple are aggressively paying down mortgage debt and are saving for retirement at a pace that would put most of their twentysomething peers to shame.
There's just one thing Lindsay, 26, and Patrick, 27, are missing. And in today's turbulent economic climate, it might be the most vital investment of all: a sufficient emergency fund.
This cash account is a kind of insurance policy against financial calamity. When you're suddenly faced with a bill you couldn't possibly have budgeted for, the money is there. In a worst-case scenario, like a computer replacing your job, the fund can cover your family's living expenses while you look for work.
The Heinekes - who only have $2,500 in cash - aren't alone in being underprepared: A third of Americans have no emergency savings, according to the National Foundation for Credit Counseling; 57% of those who have a fund don't have enough in it.
Surprisingly, Lindsay and Patrick have made a conscious decision not to have rainy-day savings. "We just feel confident that we won't need it," Patrick said when the couple first spoke to Money. They felt that their $116,000 income - from his job in custom manufacturing and hers in event marketing - was secure. And if they ever did face a disaster, they figured, they had $19,000 available on a home-equity line of credit (HELOC) to carry them over.
Dave Fernandez, a Scottsdale, Ariz. financial planner, says the Heinekes' sense of financial invulnerability is misguided - though it doesn't make them unusual. "Everyone feels secure in their jobs until they get handed a pink slip," he says. "But putting the job aside, what if their furnace or AC unit breaks? Big costs like that are always a possibility."
What's more, the HELOC may not be the guaranteed safety net the Heinekes thought it was. With home prices having dropped 9% in the past 12 months, according to Fiserv Lending Solutions, lenders have been freezing or reducing these lines in the areas that have taken the biggest hit.
Meanwhile, the real estate slump is supposed to get worse before it gets better; Fiserv projects that home values will plummet 10% in the twelve months ahead. And the job market is suffering too. Unemployment has edged up to 5.5%, the highest in almost four years, following some big layoffs. And job seekers are spending an average of 4.5 months handing out résumés, the Bureau of Labor Statistics reports. The message of the markets: Right now you can't afford not to have an emergency fund. Protect yourself by taking these steps.

1. Chart your expenses
To figure out how much you need to save, you first need to calculate how much you spend every month. As tedious as it may seem, it pays off to go over the past three months of bills to get a monthly average of your expenses. At a minimum, include:

• Mortgage payments
• Utilities, including bills for cable, Internet, landline and cell-phone service
  Groceries
• Insurance premiums, including home, auto and life. Add in at least $400 for individual health insurance - $1,000 for a family - in case the partner whose work provides it is the one to get laid off.
• Other car expenses including gas and loan payments
• Property tax (if not included in the mortgage payment)
• Discretionary spending Allow yourself some fun money. And be realistic: While there are certainly things like dinners out that you can cut back on in a pinch, don't delude yourself into thinking you can slash spending drastically.

Lindsay and Patrick calculate that their expenses are $4,750 a month. With only $1,000 in a savings account and a $1,500 buffer in their checking account, "we'd be through our savings before the month was out if one of us lost a job," admits Lindsay.
2. Measure your need
The rule of thumb is that you should have three to six months of living expenses in the bank. But your personal target depends on how stable your income is, says Tim Maurer, a Baltimore financial planner. With two salaries - which Lindsay and Patrick have - a three-month emergency fund may be sufficient in good times.
When finding a new job is tough, as it is now, it's a good idea to push that up to six months. If your family depends on a single income or if one or both of you rely heavily on commissions or bonuses, shoot for a six-month fund in safe times. And daunting as it sounds, aim for a year in uncertain times.
You can reduce the fund if you are guaranteed a severance package, but never dip below three months of cash - a lost job isn't the only potential emergency. Also, keep in mind that your fund may not be just for you. If your parents or grown-up children are likely to call on you in a crisis, you might need to tap your savings to support their emergency in addition to yours.
3. Find a place to put it
Often, the safest accounts offer interest rates that don't even keep up with inflation. "But the emergency fund isn't about yield," says David Greene, a financial planner in Fairfax, Va. Above all, you need an account that won't tumble in value and that's as liquid as cash.
Taxable stock and mutual fund accounts, while relatively easy to get at, fail the first test. When the economy is in trouble, chances are stocks are as well, making it the worst time to cash out.
The past six months have shown that home equity fails the second test. Lindsay and Patrick's HELOC is still intact. (Condo prices in Massachusetts are down only 2.6% year over year.) But since lenders have been changing the rules on HELOC equity, the Heinekes shouldn't view their line as guaranteed.
For the best combination of access, safety and yield, you have three options: a bank money-market account, a high-yield savings account and a money-market mutual fund. The first two have the benefit of being FDIC-insured for up to $100,000. And while money-market mutual funds are not insured, no individual investor has ever lost money in one.
Among these ultrasafe categories, pick the one with the highest yield. Go to bankrate.com to compare rates.
4. Build it up
Starting from scratch? Save fast. You don't want to be one emergency away from debt. Halt retirement savings - except to get your employer's full 401(k) match - and extra payments on low-interest loans until you have the target amount in the bank, says Maurer. Then resume retirement contributions.
Today, Lindsay and Patrick put $2,000 a month toward their 6% HELOC (they used $19,000 of their $38,000 line for home improvements and wedding costs). They could divert most of that to an emergency fund - still making $300 minimum payments on the HELOC. Combined with the $1,000 in their savings account, they'd be able to build a decent three-month cushion of $15,000 in nine months.
5. Look but don't touch
Once you've got the fund built, revisit it once a year and consider upping the amount if life events - like a new baby, new house or new salary - have increased your spending. Resist the temptation to use the fund for anything other than unbudgeted necessary expenses.
Hearing the planners' advice has made Patrick and Lindsay realize that they weren't as secure as they'd thought. They've decided to split their extra cash between their emergency fund and the HELOC, and they plan to move their savings from a bank account yielding a low 0.2% to a high-yield money-market account. Says Lindsay: "We've really had our eyes opened to how much risk we've had all this time."