Establishing an Emergency Fund
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If there’s one thing you can be certain of in life, it’s the uncertainties. No matter how carefully you plot out your expenses, there will always be those that you didn’t account for. You’ve got medical insurance so you think you’re okay. But what happens when you need an expensive prescription only to discover that it isn’t covered. You’ve got homeowners or renter’s insurance and you’ve insured your wedding ring. But what happens when an unexpected bundle of joy is delivered, or you decide to send your little darling to an expensive private preschool?
It’s not enough to make sure you’ve paid down your credit card debt or to make sure you are investing for your eventual retirement. An emergency fund must be a part of any sound financial plan.
Most people count on their employer for their income, tax payments, and medical benefits. But what happens when you are laid off (an increasing likelihood in this economy) and all of a sudden you are stuck with having to pay for things yourself. No matter where you stand financially, it’s going to take you awhile to get back on your feet. So most people will agree that an emergency fund makes fiscal sense. The question is how much do you need?
The standard answer to that question is that you should have three to six months of expenses set aside but in these oh so nonstandard times, that’s not necessarily enough. Keep in mind that every individual is different and your expenses will vary depending on what time of year it is. You might have a particularly expensive hobby, like going up to Lake Tahoe every weekend to ski during snow season. Or you might need to pay a piano teacher for lessons each week. If you’re thinking that these are luxuries that can be cut back on when disaster strikes, you’re right. But ideally your emergency fund should allow you to maintain the same quality of life you have now. With an unemployment rate that is at the highest it has been for the past 15 years, you may need to revise that time frame to between 6-12 months. If you are more experienced and thus higher paid, you will be at a disadvantage during this recession because it will take longer, often much longer, for you to find a job.
Your first step in establishing an emergency fund should be to set up a budget. It’s especially important to pay attention to those reoccurring payments; grocery bills, car payments, rent or mortgage payment, internet access and phone bills, electric and water bills, that can’t be entirely eliminated.
Okay, now that you’ve established the need for an emergency fund and have some idea of how much you need, you need to decide where that money should go. No, stuffing it under your mattress is not a viable option. You still need to put your money to work for you so that you can, at minimum, get ahead of inflation. Remember that you’ll need immediate access to these funds should disaster strike so forget about any accounts or investment vehicles that make you pay a penalty for early withdrawal. That’s what the financial gurus refer to as liquidity.
This is your emergency fund we are talking about so you should be as risk adverse as possible when it comes to establishing it. So forget about the stock market and put that money into an interest earning account at the highest yield possible. Mint.com’s Ways to Save can help you identify whether the interest rates and fees you are paying on your current checking and savings accounts are as good as you can get. If not, consider opening an account just for your emergency fund. In addition to checking and savings accounts, you may want to consider money market mutual funds or a certificate of deposit (CD) as places to stash your cash. Both are good, stable investment vehicles that are somewhat immune to the ups and downs of the financial markets.
Lastly, you should make sure that your credit score is high and you’ve established a solid line of credit. Worse comes to worse, you can pay for your day-to-day expenses with your credit card and defer the payments until such time as you are again gainfully employed or otherwise financially solvent. But this should remain a last resort. Make sure you pay the balance off in full each month so as not to incur finance charges. With a little advance preparation, you can weather any storm.
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4 Comments so far
leave a commentGreat points brought up here. This is more important now than ever in a time when many Americans are relying on credit cards as their emergency fund and a means for liquidity. As we’ve seen recently, lenders are cutting credit card lines drastically (available credit) and even closing down accounts entirely. This leads to an essential ‘downgrade’ in consumer credit scores (lower FICOs) due to higher utilization ratios and less credit score history available. We touched on all this in more detail here: http://www.marketfolly.com/2009/03/downgrading-american-consumers-credit.html
All in all, emergency funds are absolutely essential now, especially for those who have often over-relied on credit cards as a safety net. What happens if emergency credit card is closed or your buying power drastically reduced? A nice cash cushion is essential in an environment where cash is king.
Many companies out there suffering right now are doing so because of lack of credit… they never built up their balance sheets with cash. Now that their credit has dried up, they can’t pay for anything, their liquidity is gone. While there are obviously differences between a consumer and a business, the core of the matter is the balance sheet and cash.
Great post illustrating the essentials on how to do so effectively!
Jay
Thanks for sharing such great post, according to me there are numerous reasons when we need such emergency funds. By building an emergency fund you will feel more secure because you are prepared for the facing any financial crisis. For more details on emergency fund refer http://www.prime-targeting.com/guidelines-for-building-an-emergency-fund/
I enjoyed your article and agree that an emergency fund of cash (your credit card shouldn’t be your emergency fund, only as last resort) is necessary in any economy. However, I differ with you on two points:
1. When considering an emergency fund “trips to Tahoe and expensive hobbies” are not emergencies. If I lost my job today the last thing I’d be thinking about is taking a trip or funding my expensive hobby. For those items, I’d recommend separate accounts.
2. Placing your emergency fund into a CD would not be wise because it is usually tied up from 6 months to 1 year or more. You can’t plan emergencies, so if you have your money tied up in a CD and take it out; you will be hit with an early withdrawal penalty.
Remember: “The wise man saves for the future but the foolish man spends whatever he gets” (Proverbs 21:20)
It’s very important to have a rainy day fund set up. Luckily, I had one set up the last time I lost my job. It turned out that I couldn’t collect unemployment because of the fact my unemployment account was set up wrong. Thankfully, I had the rainy day fund set up so we made it through a time that could have been much rougher.
If you can’t seem to save anything like I couldn’t at one time there is a way to get started. Use whole dollars to pay for everything with the change collecting in a jar. After several weeks, or months, use the jar money to open a bank account. That’s how I got started being able to save.