Saving for an Emergency: Are You Prepared?
Decide How Much You'll Need, Then Make a Plan to Save It
You live within a budget, you save for retirement, you pay your bills on time. You try to do everything right when it comes to your personal finances.
And then it happens. Unexpected costs, such as car repairs and medical costs, start to mess up your perfect plan. Perhaps you can absorb such financial shocks from your regular paychecks.
But what would happen if you lost your job? Or if a major expense exceeded your income?
Every financial plan should include an emergency fund to cope with the unexpected. Think of it as a painkiller that you keep on hand for sudden financial headaches.
How Much Do You Need?
Traditionally, financial planners have suggested three to six months of reserve funds. That figure is based on the average time the unemployed have needed to search for a new job historically. Unfortunately, it took many job seekers longer to find a new position during the recent recession, so some advisers now suggest setting aside more. Indeed, a more prudent approach would be to have funds to cover six to nine months so an emergency is less likely to disrupt your long-term financial goals.
Unfortunately, many people are unprepared when a crisis hits. A 2014 Money Magazine survey found that 66 percent of American households with less than $100,000 in annual income would not be able to produce $10,000 to cover unexpected costs. More than a third of households earning more than $100,000 a year had the same fear.
Raising cash in a hurry can be expensive. Raiding a retirement account might mean tax payments, penalty fees or investment losses.
How Do You Start Saving?
Think of it as creating your own flexible spending account, without the stress of the use-it-or-lose-it scramble at the end of the year. Decide how much you really need to get through a crisis and start saving toward that goal. Put away a little at a time. Don’t stop funding your retirement account or paying down credit cards, but do start contributing something.
The amount you need may be less than you expect. You don’t have to put away a half-year’s salary. Focus on costs, not income. People in crisis cut back on luxury items, entertainment and other discretionary expenses. So all you need is a barebones calculation of items you absolutely need to pay. Your mortgage or rent, payments on car loans and other credit accounts, utilities, transportation and child care, plus what it might cost for medical insurance or expenses if you lose coverage that came from your job.
How Should You Keep It Safe?
One of the myths of emergency funds is that you need to keep them in pure cash. In reality, you should keep the assets liquid, meaning you could get at them in a hurry. Money-market funds, certificates of deposit and short-term bond funds can generate income while giving you ready access to your money when you need it. Earning that income is important, because, if you are lucky, that fund will sit unused for years. Even if inflation is low, you want your money to keep pace with consumer prices so it has the same buying power when you need to tap your reserves.
With a bit of foresight, the fund you set up can be a cost saver, an income source and a stress reliever. More importantly, it can help you keep unexpected costs from becoming real emergencies.
Richard Satran is a freelance journalist who has been an editor at U.S. News & World Report, CNBC and Reuters.