One of the first steps I help clients focus on is building or maintaining an emergency fund. As basic as it is, it can be a hard thing for some folks to commit to. I often feel like I’m being Debbie Downer when I have to focus on negative “what if” scenarios in life, but that’s part of helping people be financially prepared. I think the difficulty that comes in committing to an emergency fund boils down to a few key points that we need to go over and get over:
It sounds awful.
Who gets joy in putting money away for a potential disaster? It sounds like we’re just asking for trouble. Well, unfortunately, stuff happens but if you’re afraid the law of attraction forces will take you up on this, let’s give the Emergency Fund a PR makeover. I sometimes have clients call it their Cash Cushion or a Financial Independence Account or an Opportunity Fund. If you need to put a positive label on it, fine. Just don’t let the name hold you back.
It takes time to build up the account.
Depending on your income sources and number of family members, most experts recommend having a cash cushion (see how I’m using a positive focus?) to cover 3 to 9 months of core living expenses. That may sound like a lot of money, but statistically we have seen where job loss or a disability can keep people out of work that long or longer. Having adequate funds put aside will give you options and time so you can make decisions strategically, not out of fear. It will take some time to build up such reserves, but it can be done with consistent saving each month.The easiest way to get started for most people is to set up a savings account and have an automatic contribution made from pay into the savings account.
People think they can rely on their retirement accounts.
While it is a back up option when getting started, it should not be your ongoing primary resource. You don’t want to rely on tapping retirement accounts that will trigger penalties for early withdrawals before you reach age 59 1/2 as well as ordinary taxes. Not to mention that by using this strategy, you may have to step out of the investment market for a period of time. Since time is your ally in retirement planning, and we never know when markets will go up or down, having funds out of your accounts can have a prolonged negative impact.
The one strategy that can work for some people in getting started is to use a Roth IRA account to hold cash positions while also building a cash cushion account outside of their Roth. This way they take advantage of getting money into a Roth account and once the other cash account is built up, they can begin to invest the cash in their Roth accounts. It is not ideal for a long term strategy but a good way to get started if you qualify for opening a Roth and have limited funds. You can read more about this strategy in an article written by Gail Marx Jarvis of the Chicago Tribune Roth IRA can be a back-up emergency fund.
People think they can rely on their credit cards.
It’s true that credit cards can be useful when something unexpected comes up, but you will have to pay interest on any amount you charge unless you pay the balance in full right away. If you’re on a tight budget, the last thing you need to do is rack up debt.
It’s boring and the money is just sitting there.
It’s hard for people to get excited about an emergency fund when the investment markets are doing well and cash savings accounts are yielding next to nothing. I hear people say they want to put this cash to work; but, as with the retirement accounts, earmarking investment accounts for emergencies is risky. Emergencies don’t hit at predictable times so, when you really need the money, you may have to sell securities at a loss to cover the emergency. Having a cushion allows you to ride out a down market without the need to tap a portfolio (stocks or bonds) that has lost value. Sorry, but there are no free lunches and I don’t time the markets. Instead, try looking at higher yielding money market accounts that are FDIC insured and even CDs with short penalties if you need to terminate them before they mature but do your home work to compare features not just rates. A good site to start your research on is DepositAccounts.com. FYI, I do not receive any benefit from them for providing this link.
Still not sure why you need an emergency fund?
Some people pride themselves on having a good handle on their finances. They pay their bills in full and on time each and every month. They manage their credit cards expertly, and even though they could get all the credit they want with ease, they refrain from opening new accounts that they don’t need. If this is you and you still don’t see a reason to have an emergency fund, let me share with you how you could still find yourself in trouble without a cash cushion. Here are the top situations I see that frequently get people into financial problems:
- Job loss due to layoffs, health issues and disabilities
- Large medical bills
- Caregiver responsibilities – a sick child or spouse, an aging parent requiring your time and attention
- Break downs, wear outs – cars, appliances, etc.
- An unplanned business or lifetime opportunity
No matter what your income level, you just never know what could happen. When the unexpected hits, having a cash cushion can prevent it from sending your finances into chaos.
Tell me your thoughts on an emergency reserve and if you struggle with funding one.
Image courtesy of Stuart Miles/ FreeDigitalPhotos.net