August 2, 2014

How to Create a Cash Cushion / Emergency Fund

It is a lack of personal savings that forces us to use our credit cards or obtain personal loans to pay for the expenses we incur in our lives.   Many of these expenses are unplanned expenses for car repairs, kid’s braces, home repairs, etc.  We also use our credit cards for pay for other large expenses i.e. vacations, holiday shopping, home furnishings, etc.  These large expenses dramatically impact our overall debt, increase the costs of every purchase due to the interest we pay over time,  and also reduces or eliminates our ability to save money and fund our retirement on a monthly basis.  A cash cushion is a simple financial solution.

What is a Cash Cushion – A cash cushion is a separate fund that is established and set aside solely to be used for the purpose of covering these unforeseen expenses, repairs, etc. that come up in everyday life.  As a result, this will keep you from incurring these expenses on your credit card when emergencies arise.

Why it is Important – By eliminating the need to utilize credit cards for unforeseen expenses you can focus on limiting your use of credit.  You can establish and commit to a plan to pay off all consumer debt.   What is the benefit of a cash cushion?  Debt free living and the peace of mind that comes from knowing that you have some cash to fall back on in an emergency.

How to Fund Your Cash Cushion – The key to funding your cash cushion is controlling your spending.  All of us can free up the cash we need to fund our cash cushion if we take the time to track all of our expenses for 30 days.  We can also look for creative ways to reduce our discretionary lifestyle expenses for lattes, dining out, pleasure shopping, etc.  We can also look for ways to live more frugally.  If you are willing to make the effort, I am confident you can find enough cash to start funding your cash cushion.  If you need some ideas on reducing your expenses look under our debt free living section at http://www.fiscalliteracy.com/

How Much Cash?   This is only a question that you can answer based on your individual financial situation.  However, I think it is a great idea to work through several different unforeseen expense scenarios.  This exercise will help you to get an idea of how much cash may be required to keep you from using  a credit card to cover the expenses.   This most important point is to commit to establishing a cash cushion and funding it every month.  This discipline and commitment will pay significant dividends when an unforeseen or unexpected expense arises.

Where to Keep Your Cash – It is vitally important to set aside this cash in a separate account where you will not be tempted to spend it.  Remember, a cash cushion is for unforeseen and unexpected expenses.  Therefore, this money must always be available to you to cover those emergencies and save you from using your credit cards.   Therefore, I suggest that you set up a separate account at a different institution from your normal bank accounts.  This will prevent you from easily transferring the money to another account.   Select an account type like a savings account or a money market account that does not put your money at risk.

I hope you have benefited from this post on Financial Literacy.  If so, leave a comment.  In addition, please forward this to anyone you think might benefit from this short financial literacy lesson.

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