Building an emergency fund

Establishing an emergency savings account is vital in good times and in bad. The purpose of the fund is to sock away three to six months' living expenses. But this money could also be used when you're staring at major, unplanned expenses such as a car breakdown or a leaky roof.

What's important is that you put the money away consistently, and then tap it only for true emergencies. The success of any long-range savings plan depends less on the rate of return than on consistently putting money away and leaving it there.

Lock it up and hide the key
People who are living on a lean-and-mean budget will have the toughest time setting aside money for emergencies. If it's possible to squeeze out another $40 or $50 each month and put it in a money market account, it's worth doing.

Morris Armstrong, a certified financial planner based in New Milford, Conn., says to treat the emergency fund as a bill.

"If you determine you need $3,000 in the fund, look at what you can afford to save each month and use it as a bill to pay yourself," says Armstrong. "If it's $100 a month, that's fine. Put it away and let it grow.

"When you've saved the $3,000 you'll be in the habit of putting away that $50 or $100 a month. Keep doing it. Maybe put it in a nonretirement brokerage account."

Other experts echo the idea of treating the emergency fund as a bill. Put the money away and don't be tempted by the latest sale.

Putting money aside on your own is hard. Retirement plans are successful because the money comes out of your paycheck before you can get your hands on it and because there are taxes and penalties for early withdrawals.

But stashing money in an easy access money market account takes discipline.

"Once you've got the money in your checkbook, there are all these demands coming at you -- the mortgage, taxes, the kid's braces, McDonald's," says certified financial planner Chris Cooper of Toledo, Ohio.

"Then we have this idiot box, the TV, with somebody yelling, 'Zero-percent interest, buy this now!' People get overwhelmed. They know they're not supposed to spend the money, but they do."

Limiting your access to the emergency fund may help. You need to have immediate access to some of the money, but not all of it.

As you're growing your emergency fund, consider keeping it in a money market account or fund until you have about two months of living expenses. Move one month of expenses to a one-month CD. When the CD matures, roll the principal and interest into another one-month CD.

All the while, continue making regular payments to the emergency fund money market account. Eventually, you'll have another month of living expenses that can be used to invest in a two- or three-month CD. If you are opting to set aside six months of expenses, continue the process until you can comfortably purchase a six-month CD.

Paying your future self
But before you can stash it aside, you need to get started building it.

Whatever financial situation you're in, the first step in building an emergency fund is to figure out where your money is going, according to Tom Grzymala of Alexandria Financial Associates in Alexandria, Va.

"People don't know where they're spending money," says Grzymala. "If they're bringing home $70,000, they can only account for $50,000.