Setting up an emergency fund is essential to getting--and keeping--your finances in order, and should be one of your first priorities. Creating a safety net for yourself can be just as important as paying down debt, as it protects you from digging yourself into an even deeper hole should an unexpected expense arise.
Ensure you have enough to protect you from the unexpected in your emergency fund before you do any other investing.
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. How much time would you like to have to find a new job if you lost yours?
The more you get paid, the more you'll need in your emergency fund. That's because if you do lose a high-paying job, it takes longer, on average, to find a comparable position than if you're in a lower-paying job.
Once you know the total amount you'd like to set aside, the next step is to figure out how much you will need to save each month, and where you can cut back in spending to reach your goal. Creating a budget can help you identify non-essential 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. Click here for more cost-cutting ideas.
If the amount seems overwhelming, set an initial goal of having enough to cover 3 months. Once you reach that first goal, aim for 6 months.
Put the first three to six months worth of savings in highly liquid, stable investments, such as a money market account or fund. You want to be able to access this money easily in case the unexpected happens. Certificates of Deposit (CDs) are also an option, but are slightly less liquid. Click here for an overview of short-term savings options.
Many money market accounts and funds allow you to set up automatic investments, which ensures you will contribute each month. You won't earn much interest on this money, but at least you can rest easy knowing you won't need to tap your long-term assets or go into debt in an emergency.
If you are saving enough to cover a more extended period, you can put money beyond what you would need immediately into a short-term bond fund to capture more yield. The trade-off is that short-term bond funds can be more volatile, so they only make sense for the money you would not need right away.