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By Rachel Haig | 04-20-2010 03:44 AM

Emergency Fund Preparedness

How much is enough for your emergency fund, and where should you keep the money?

Rachel Haig: Hi, I'm Rachel Haig for Morningstar.com. Think about where money would come from if you had an unexpected home repair or car repair, or if you lost your job. A scary thought, right? That's precisely why you need an emergency fund. It can provide a cushion in those tough situations.

An emergency fund is money set aside to cover unforeseen expenses, to be used when the alternatives are tapping your longer-term investments or going into debt. Setting up an emergency fund is essential to getting and keeping your financial house in order. It should be the first thing you do before you do any other investing.

So, how much is enough? Typical financial-planner wisdom says to save enough to cover three to six months' worth of expenses, but it's best to save more if possible. Think about this this way. How much time would you like to have to find a new job if you lost yours?

The more you earn at your job, the more you'll need in your emergency fund. That's because it takes longer, on average, to find a comparable high-paying position than if you're in a lower-paying job.

The next step is to figure out how much you'll need to save each month and where you can cut back to meet your goal. Creating a budget can help you identify nonessential spending. Simple steps, like brewing your own coffee and cooking a few more nights a week, can save you a significant amount without requiring a big sacrifice.

If the amount seems overwhelming, set an initial goal of saving enough to cover three months' worth of expenses. Once you reach that first goal, aim for six months.

So, where should you put the money you're saving? The first three to six months' worth should go in highly liquid, stable investments. Consider a money-market fund or a money-market account. You want to be able to access this money easily in case the unexpected happens.

Many money-market accounts and funds allow you to set up automatic investments, which ensure that you'll contribute each month. Certificates of deposit, or CDs, are also an option, but are slightly less liquid.

Now, you won't earn much interest on this money, but at least you can rest easy knowing that you won't need to tap your long-term assets or go into debt in the event of an emergency.

If you're saving for a more extended period, you can take on a little bit more risk by putting some of it into a short-term bond fund. Short-term bond funds allow you to capture more yield, but they can also be more volatile, so they only make sense for the money you would not need right away. Two funds that we like are Vanguard Short-Term Bond Index and T. Rowe Price Short-Term Bond.

Taking the steps to set up an emergency fund are crucial to getting your financial house in order. For Morningstar.com, I'm Rachel Haig.

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