By Laura McMullen
Say 2017 has a rocky start -- maybe your car needs repairs that will set you back $1,000. Would you have the money available? This is the kind of unexpected expense that an emergency fund could cover, preventing you from taking on debt.
If you don't have an emergency fund, make a New Year's resolution to build one. Here's how to start.
Open a savings account. For an emergency fund to be useful, it must be handy. Tap a certificate of deposit or your 401(k) for those car repairs, and you'll face hefty early-withdrawal penalties. Keep your emergency fund in its own savings account, which you can access easily and for free. This account should be separate from one where you save for short-term goals, such as paying for a vacation.
Start small and keep saving. An emergency fund that's too small won't be able to cover life's unexpected scrapes. Replacing a broken water heater could send you into debt, for example. But an emergency fund that's too big has its own drawbacks. With more cushion than necessary, those extra funds will earn little in interest in a savings account when they could be growing more quickly in investments or paying off high-interest debt.
To find the sweet spot, aim to start with $500. That can be enough to keep you from having to take cold showers. Continue adding to your safety net so you're prepared for bigger crises, like losing your job. Build up to a fund that would eventually cover living expenses for three months, then work up to six months.
Figure out exactly how much to save. Determine how much money to set aside for your fund by tallying the monthly costs of indispensable needs. Account for electricity, heat, water, food, rent, health care, insurance and payments for your mortgage and car. (Nice-to-haves, such as cable, don't make the list.) Multiply the sum of those costs by the number of months -- aim for three to six -- you're aiming to cover.
This formula isn't a perfect science, given that everyone's situation is different. If you're the breadwinner for your family or are expecting a child, for example, you may want to shoot for a larger fund.
Diversify your savings. You'll likely have to toggle between other priorities, such as long-term savings, as you work up to this three- to six-month goal. For most people, that means contributing to a 401(k) or other tax-advantaged retirement account while growing an emergency fund. If your employer offers a 401(k) match, contribute at least enough to get the maximum. After you snag the match, start tackling whatever you have in toxic debt, like high-interest personal loans and payday loans.
Once you've built an emergency fund that covers up to six months, direct your savings entirely to retirement and debt repayment. If you have to dip into your emergency fund later, you can always divert money back to the safety net to replenish it.