Building a rainy day fund? Avoid these 6 common mistakes.
Don't become paralyzed by the amount of money you need to save
If you're like a majority of Americans, you probably have less than $1,000 in your savings account. You might not even have a savings account to begin with.
Under those circumstances, even a relatively minor life hiccup could throw you for a loop. Having an emergency fund — that bulwark against the hefty bills that can come with unexpected events — can keep your stress level down and prevent you from making bad financial decisions. But in order for that to happen, you need to avoid some bad decisions regarding the emergency fund itself. Here, six of the biggest mistakes to avoid:
1. Using credit cards or your retirement account as your emergency fund.
Don't do it. Credit cards are deceptive. Sure, they'll cover an unexpected bill, but unless you can pay off your balance each month, the interest will quickly mount and create more debt at a time when you're already strapped for cash.
As for retirement accounts, raiding them early is likely to set you back in your retirement savings, not only depleting your nut but robbing you of all the compound interest that would be accruing if you left the money alone. Other drawbacks: You may get hit with a 10 percent early withdrawal penalty if you're younger than 59 ½, and the money may be considered taxable income. There are special rules around "hardship distributions" and account loans, which may avoid taxes and penalties. Still, it's far better to build emergency savings elsewhere.
2. Becoming paralyzed by the amount of money you need to save.
Experts advise setting aside three to six months' worth of living expenses, but anything is better than nothing. "Five hundred dollars will get you out of many scrapes that would otherwise put you in the hole," NerdWallet points out. If you're feeling daunted, break your goal into pieces — say, a certain amount of savings per week — so that it feels more doable. To get a boost, consider short-term spending cuts: Forget Starbucks, cancel the cable, stop ordering takeout.
3. Not keeping your emergency funds in a separate account.
If you keep all your money in one place — say, your regular checking account — you'll be more tempted to dip into your reserves. Emergency funds should be put into a separate savings account in an FDIC-insured bank. (That way, in the event of a bank failure, the money is guaranteed up to $250,000.) While building the fund, you can help keep yourself on track by setting up automatic monthly transfers from your checking to your savings account. Another option is a low-risk money market account that comes with a debit card or check-writing privileges.
4. Investing your emergency fund.
So you've finally built up this sweet lump sum and you're expected to let it just sit around? Basically, yes. It's understandable if you find savings account interest rates to be depressing. Even high-yield savings accounts only hover around 1 percent. But taking your money for a ride in the stock market brings a lot of risk. And emergency funds above all are meant to be both stable and accessible — the money you can count on being there when you need it.
5. Breaking into the fund for non-emergency reasons.
First, the easy stuff: The latest iPhone release, new boots, and the last-minute travel deal for a weekend getaway do not constitute emergencies.
For some people, the line blurs when they find themselves facing annual or occasional expenses. Think tax payments, holiday gifts, back-to-school-shopping, standard household or car maintenance, or vet visits. But these situations are all predictable — even if the exact amount of money you'll be spending isn't — and should be factored into your regular budget. It may help to open a separate savings fund for these kinds of expenses.
True financial emergencies are unforeseen and require immediate attention. Typically, this includes dealing with unemployment or medical or dental emergencies. Car repairs, especially if it's your only mode of transportation, and major household repairs like a broken heater in the winter or a leaking roof also qualify. Unexpected travel, such as in the event of a funeral, is another reason to dip into the fund.
6. Not rebuilding your fund.
It's important to give yourself permission to take money out in the case of a true emergency — that's why it's there. But as soon as you're able, start replenishing the fund. You never know when you'll need it again.