Yeah, I know, totally not a fun or sexy topic. I wish I could tell you that once you pay off all your debts you can blow your money on something fun like a trip to Rome to meet hot Italians but alas no, we have a few more steps to take in order to enjoy la dolce vita.
An emergency fund is pretty much self-explanatory with the money being available for emergencies, whether that be losing your job, temporary disability/illness, needing to replace the snow tires on your tractor, etc. The emergency fund is meant to replace your reliance on your credit cards to see you through an emergency.
First you need to decide how much money should be in your emergency fund. Collective wisdom is that your emergency fund should be three to six months worth of living expenses. I would aim for six months to be on the safe side. The good news is that your living expenses are have already been determined on your budget!
Open up a separate savings account specifically for this money and I strongly recommend that you set up an automatic transfer to this account so that it doesn’t get forgotten or missed (accidentally of course). Now start saving!
When you have accumulated your goal amount or at least a significant portion of it, speak with a financial adviser about putting the money into a higher-yield savings vehicle. This might be a money market account, a short term certificate of deposit, etc. Your two requirements should be 1) it is 100% secure, backed by federal deposit insurance and 2) it be relatively liquid because emergencies need money now.
So if an emergency fund is so important, why am I telling you to save for one after you’ve paid off your debts? Because the interest rates you’re paying on your debts is going to be higher than the interest rate that the bank is going to pay you. However an emergency fund is completely necessary if you ever want to get out of panic mode with your finances.