Finance Globe

U.S. financial and economic topics from several finance writers.
8 minutes reading time (1673 words)

Put an Emergency Fund on Your To-Do List

An emergency fund helps to get you emergency.
According to a poll, only 4 in 10 Americans have an adequate emergency fund to fall back on. With three to six months of living expenses being the recommended savings, it's easy to see why. Putting away enough money in an emergency fund can take a typical family several years to build up. And all the while, there's the possibility that an emergency will come up, requiring a withdrawal and eventually having to start building the emergency fund all over again.

But though it may take careful budgeting and solid discipline to grow your emergency fund, it's the safest and least costly way to get through hard times. Alternatives would be to live off your credit cards, sell your assets, or dramatically lower your standard of living. Worst-case scenarios may leave you to face repossessions, foreclosure, or bankruptcy. Protect your financial security, and start building your emergency fund as soon as possible.

What first, start your emergency fund or pay off debts?
It mathematically makes sense to pay off balances costing 12-20% annually before you sock away emergency money earning less than 3%. You'll have no choice but to incur new credit card charges if you have a serious emergency before you get a chance to build up your three to six months' worth of savings, but you'll be losing money if you don't eliminate your credit card balances first.

There's also the hopeful chance that you won't even have an emergency before you've had a chance to save, and paying off those high-interest debts first will make it easier to save for your emergency fund later, since you'll have more disposable cash when your credit card payments are no longer taking a chunk of your budget.

And the truth is, that credit cards were made for emergencies. They're instant financing if you find yourself in a bind. They become very expensive if you charge more than you should and carry balances month to month, but they really come in handy and can save you when you don't have the cash in the bank. So pay them off first, but know that you can use a credit card for nearly any expense if you really need to. Just avoid running up new charges unless it really is necessary.

On the other hand, if you save the three to six months' worth of expenses first, and can only pay the minimum payments on your cards, you could be dragging out your credit card debt for decades. You may later even become tempted to pull out your emergency savings to eliminate your high-interest credit card debt, which would put you even worse than where you started. But, to be on the safe side, first save a month or two of rent or mortgage payments, and then begin paying your credit cards as quickly as you can afford to.

Now, the whole reason for establishing an emergency fund is to avoid the need to incur credit card charges and other debts in the first place. But many consumers' financial troubles are due to living beyond their means with the over-use of credit cards, spending more than they can pay off each month. They don't reserve our credit cards for strict emergencies, but swipe-and-go to collect reward points for restaraunt meals, vacations, and the latest gadgets. Change this way of spending if you want to benefit from paying down the credit cards first.

But it's unrealistic to attempt to eliminate all your debt before stashing emergency cash. Low-interest debts, like student loans, auto loans, and mortgages should fit into your normal budget, and it would be difficult or impossible to take the cash back out if you need it after you prepay on them. So get your emergency savings fully funded before worrying about paying off these types of loans.

Finding the money to save
Living within your means is the first step to financial security, and it may take some cutting back to ensure that you can afford the life you've chosen to live. If you have credit card balances to pay off first, then finding the money to save shouldn't be too hard once your balances are down to zero. Just start saving the same amount that you were sending to your credit cards, and you shouldn't even miss the cash.

Just like any of your other financial objectives, starting your emergency fund requires careful planning and a realistic budget. Whether you can save $25 or $300 each month is not an issue, as long as you save what you can each month, and as long as you do it regularly. Over time, the account balance will grow and you'll be able to rest assured that you have enough to fall back on if the need arises.

While it's important to begin saving for emergencies, it's also important to be able to afford the lifestyle you live now. Saving in an emergency fund is a gradual process, and approaching it full-speed ahead may make it difficult to keep up with your current obligations. If you are putting away so much into your emergency fund that you have to put more on your credit card than you can pay off every month, then you'll need to reduce the amount you put into the emergency fund so that it doesn't interfere with paying your daily expenses.

Some families may find it difficult to make ends meet each month even without saving for their emergency fund, and finding extra money to save can be a real test. You may have to take a serious look at what you're spending your money on and make a few sacrifices for your family's security. Unexpected expenses or a job loss can do much more damage to your finances if you are using nearly all your income to get by each month.

Figure out how much to save, whether a dollar amount each month or a certain percentage of every paycheck, and then put it directly into your emergency fund before you have a chance to use it for non-emergencies. Automatic deposits can be set up through your financial institution, so that you'll never forget to put money away. Just make sure you don't forget to deduct that amount from your account balance, to avoid over-draft fees. It won't be difficult to budget for your emergency savings when you learn to treat it like any other regular monthly bill.

Where to put your emergency savings
Emergency savings can be put in a highly liquid, government-insured account with your financial institution. Liquidity is important in an emergency fund, which means that you will have immediate access to your cash if you need it. Safety is also important, so you can be sure that its value has not declined by the time you have to cash out.

Stocks and mutual funds are generally not a good place to keep emergency funds, because you may have no choice but to sell shares at a loss if the market is down when you need the money. Real estate is also not a good place to keep your emergency stash, since it may take many months to sell it. And you don't want to have to sell your home or get a home-equity loan just because you've suffered a temporary loss of cash-flow or an increase in expenses.

A regular savings account is an easy choice, since they have a very low minimum balance requirement, if they have one at all. But they are typically the worst-paying types of accounts; the current interest rates on a bank savings account is pretty laughable. Still, the regular savings account does have its place in your emergency savings strategy. You can use a savings account to save up until you have enough to move it into a better-paying type of account.

Money market accounts pay a little better than a regular savings account, though you usually need a significant account balance to reap those higher rates. Money market accounts are similar to an interest-bearing checking account, complete with checks and ATM/debit cards. You are limited to six withdrawals a month, but that shouldn't be a concern since you'll only pull money out for an emergency. Financial institutions often have a minimum deposit requirement of $1000-$2500 to open a money market account.

Certificates of Deposit (CDs) can be a good choice for emergency savings, and they typically pay better than a savings account. The main consideration is that CDs incur penalties if you cash out before the maturity date. Since you can't predict the date you'll need emergency funds, you can get around the penalties if you stagger your CD maturity dates so that money is available each month or so. This way, you'll always have a CD that can be cashed in if you need it, without penalty. CD minimums may range from several hundred dollars to a thousand dollars, depending on the financial institution.

A money market fund is not FDIC or NCUA insured, and it's exposed to some market risk because it actually is a mutual fund. But the risk is minimal; no consumer has actually ever lost money in a money market fund. Though money market funds aren't government-insured, they are highly government-regulated. Money market funds can be a great place to sock away emergency money, since they are a pretty safe investment, while earning more interest than bank alternatives. Your financial institution may offer money market funds, or you can check with any brokerage house. Minimum deposits are typically in the $1000-$2500 range.

Where ever you decide to put your emergency savings, it's important to keep it separate from the checking account you use for regular expenses. It's way too easy to dip into emergency cash if you see it there everyday. Even if you have the discipline to not spend it, keeping it separate will allow you to earn a better return on your savings than the typical checking account pays.

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Saturday, 15 June 2024

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