May 4, 2015 in Smart Money

Jean Chatzky: Rebuild an emergency fund

Should you use your emergency fund to pay off debt?

The answer depends on how much you have in that emergency stash, says Greg McBride, CFA, Bankrate’s chief financial analyst. “If you have an adequately padded emergency fund and you have the luxury of using it to pay off high interest rate credit card debt, then go for it. But if your emergency savings mirror how much debt you have, then don’t do it. It would be detrimental to wipe out your emergency savings to pay off credit card debt.”

Using your emergency savings for emergencies, however, is always a good idea rather than floating the cost on a credit card you can’t pay off in full. After all, that’s what the money is there for.

Whether you decide to pay off some debt with your emergency cash, or a sudden expense comes along that drains your stash, you’ll need to build it back up. Here’s the best way to do that:

Set a goal. HelloWallet just released a white paper with a compelling argument: When building an emergency cushion, you should focus on saving enough for three categories: minor emergencies, major emergencies and job loss. Minor emergencies include small car repairs, small home repairs, and your health care deductibles. Major emergencies are major car and home repairs and your health care out-of-pocket max. And job loss is a year’s worth of expenses, less any income (like unemployment insurance or your spouse’s salary).

“I think that the old three- to six-months goal is going to be OK for some people, but it’s better to have an element of personalization to help you zero in on what you’d be able to cover and what you wouldn’t given your level of savings,” says Aron Szapiro, the company’s policy and finance expert. Luckily, you don’t have to do all the math; HelloWallet has a calculator to guide you.

Bankrate also has an emergency savings calculator.

Work your way up. If the amount the calculator suggests seems insurmountable, the goal is to slowly work your way there. Start by covering the minor emergencies. Once you have that cash set aside, move on to major emergencies and finally, job loss. Even having $1,000 in the bank can help you out of a jam, so every little bit you set aside helps. Reaching small goals will give you the motivation to shoot for larger ones.

“You’ll soon see that you’re not totally living paycheck to paycheck. You’ll be able to withstand a good number of shocks. And that will helpfully give people the confidence to save more,” Szapiro says.

Make it automatic. This is my favorite way to accomplish any savings goal: Have the money transferred each month by your bank, so you don’t have the opportunity to spend it. “The biggest barrier for saving is not being in the habit of saving. That’s why the direct deposit is so important, because it happens automatically for you. If you wait until the end of the month to save, it’s probably not going to happen,” McBride says.