Many people hear the term financial planning and they automatically think about investing money with a broker to save for retirement. Or maybe setting up a 529 college savings plan to save for their children’s education. Emergency fund is often not at the top of the list.
But these are future goals, usually planned for with riskier and generally longer term investments such as stocks and bonds. Before addressing the future, you need to address and protect the present.
One of the first steps many financial experts recommend, even before paying off high interest rate consumer credit card debt, is to establish an easily accessible emergency fund. The typical recommendation is to maintain a fund sufficient to cover about three to six months of living expenses.
Why Do I Need An Emergency Fund?
Many Americans do not have sufficient cash savings for a financial emergency. Are you among them? If so, whom or where will you turn to in a time of need to prevent potential suffering for yourself or your family? Emergencies can sneak up on you when you least expect it. They can disrupt your life and put other financial goals in jeopardy.
Job loss and underemployment are very common in today’s slow economic environment. Unforeseen medical or dental bills can become a reality due to illness or an accident. Or you may possibly face a lawsuit in today’s litigious society. Even taking time off to care for a loved one can create a sudden financial need.
Counting on friends and family or a bank for a bailout may not be a good idea
Sure, parents and other family and friends may be ready and willing to help. But what if their circumstances change and they can’t step up when you need them most? Further, you don’t want to risk straining relationships. This often happens when you are unable to pay back a loan to someone close to you.
Or maybe you have too much pride to ask for a handout if you found yourself in such a bind. Even borrowing from a bank with a line of credit or one of their tempting (temporary) zero interest credit card offers is generally not a good idea.
It is easy and tempting to go into debt, but often very difficult to get out of it. Also, your ability to borrow may be okay now. But your borrowing capacity may be diminished if your finances deteriorate as may be the case in an emergency.
They do say that stress kills, and not having a financial safety net in place does and should create stress. So put some money aside and sleep better at night.
How am I to save for an emergency fund if I can barely pay my expenses as it is?
Well, the answer lies in four important words you have likely heard before. “Live within your means.” In order to do this, you may need to commit to a personal budget. Regardless, suffice it to say that you must ultimately increase income and/or cut expenses.
You want to do this to the point where you can save at least 10% to 15% of your income. You can save more or less. But this is a good guideline if you want to save meaningful sums over time. When you look at your pay stub, it is important to understand that you do not really make the amount it says you do.
Besides the amounts withheld for taxes and other benefits such as health insurance, you really make about 85% of the net amount you see on your check. The rest needs to go to savings. The savings may go towards building an emergency fund, paying down debt, or investing for future goals. Unless your financial goals are already funded, the ability to save is really essential.
It may make you sad or apprehensive to have to cut back on eating at your favorite restaurant. Or buying your coffee at the local Starbucks. But the peace of mind you will gain will be more than worth it in the long run. Now these are among the easier items to cut. Sometimes it’s necessary to go as far as downsizing your home or giving up owning a car. Some sacrifice will be necessary in order to get your finances in order if you find yourself unable to save money.
The inability to save is usually a result of living above your means. Be frugal and shop wisely. Now cutting expenses is not the only way. Increasing your income is another option. You can get a side or part-time job to supplement your income.
Alternatively, getting a raise at your current job or switching to a higher paying one can also do the trick. Ideally, you should both cut expenses and increase income if possible. However, most people find it easier to cut back on expenses, especially ones that are discretionary and frivolous.
So when can I dip into my emergency fund? And what types of expenses should be paid for with these funds?
If you lose your job, for example, you will need to pay your basic necessities until you find another job. This will include expenses such as your mortgage, utility bills, insurance, property taxes, and groceries. Alternatively, you may have your job but may get hit with an unexpected legal action or a sizable medical bill. Instead of skipping your mortgage payment and hurting your credit score, you can dip into your emergency cash and take care of the bill.
Even such items as repairing a leaky roof or replacing a malfunctioning boiler may constitute emergencies. Acquiring a car may also be an emergency. You may need it for work, and access to another car, biking, or using mass transit are not options. Just don’t go for more car than you really need, especially if the funds are coming out of your emergency account.
These funds are NOT to be used to buy that new cool phone that just came out, or those new high fashion shoes you’ve been eyeing. Keep in mind that it is imperative that you replenish the fund when it is used. Obviously you will likely not be able to do this immediately. But start by putting a portion of your income into the account until it is replenished.
Also, it is a good idea to establish a separate account for your emergency stash. Commingling the funds with the money in your main everyday checking account is not recommended. This way the money will not be inadvertently spent.
Where should I keep my emergency cash?
You have a few options as to where to keep your cash. Under the mattress is generally not a good idea for several obvious reasons. So look for a bank with a very low or no minimum balance requirement. This way you can avoid unnecessary fees while building up your emergency reserves.
Interest rates these days are still very low on a historical basis. But you can also shop around for a relatively higher yield. Savings and money market accounts are recommended. Try to avoid locking all your money up in something like a certificate of deposit (CD). They do have somewhat higher rates, but you may pay a penalty to access your money before the CD matures.
You may however invest portions of your funds in shorter term CDs for the higher interest yield. Just make sure at least one month worth of expenses is available at all times. Sometimes you can even park your money in a brokerage account. You may be able to find a higher yield here, but you will have to resist any temptation or sales pitch to invest the funds.
I have other assets I can use in an emergency, why do I need an emergency fund?
Other assets such as stocks are liquid. But selling them at an inopportune time can cost you even more money, not to mention a higher tax bill, and also put a dent in your future financial goals such as retirement or college planning. The emergency funds should be in a taxable account.
This means that you should also not use an IRA or other pension or retirement plan account for emergencies. Funds from these types of accounts are for a specific purpose and should only be used as a last resort.
Besides the taxes you may incur by withdrawing from these accounts, you may also incur penalties if you are under 59 1/2 years old, for example. But even withdrawing from Roth IRA accounts where most of the funds may be taken out tax free is not a good idea.
These retirement accounts have limits as to how much money may be contributed each year for retirement. So every dollar the government allows you to put into these accounts should ultimately be invested in accomplishing your future retirement goals by taking advantage of their tax deferred status.
Should I start an emergency fund before paying off high interest credit card debt?
There is some debate as to whether or not you should pay off high interest consumer debt such as credit card balances before you establish an emergency fund. There is some validity to this line of thinking. And there is nothing wrong with doing this first if you have the ability to do so. However, there are a couple of things to consider if you go this route.
First, there is no guarantee that you will be able to access your credit card for cash in an emergency. Your credit limit may be maxed out and you may not be able to draw cash when you need it most. Also, your financial situation may cause the credit card company to cut back on your credit without you knowing it. This can also leave you in a bind.
Finally, for those who have no savings and maybe have never saved any of their earnings in the past, it can be a huge psychological boost to do so.
Get Started on the Emergency Fund and Finish It Later
Once you make a commitment to getting your financial house in order, saving some money and having it available in a savings account can provide motivation. It can provide a glimpse into what is possible. If you do have high interest credit card debt, it is understandable and logical you would want to pay it off as soon as possible.
So a sensible solution in such as situation may be to save about one month worth of living expenses in an easily accessible bank account. Then immediately get to work on paying down your credit card debt.
Then, once the high interest debt is paid off, you can get back to building up your emergency fund. Aim for a minimum of three months worth of expenses, and ultimately potentially up to six. It is generally not recommended to save much more than six months to a year of living expenses.
The reasoning behind this is that these short-term liquid funds will generally underperform riskier investments over time. Cash and equivalents have returned less historically than long term investments such as stocks and bonds over long time periods.
When should I start saving for an emergency reserve fund?
What are you waiting for? If you are one of the non-savers mentioned above, it’s never too late to build your emergency stash. Carve out a portion of your income and cut back on expenses. Then get to researching some financial institutions where you may be able to park your cash.
Take action now and put your mind at ease! Then you can be on your way to saving for more exciting goals. These can include retirement, saving for college, or buying that vacation home!