May 3, 2013
A basic tenet of personal finance that gets short shrift but can dramatically improve your money life is having a cash emergency fund.
It's especially important for some to consider this time of year, as new high school and college graduates make their way in the world and soon-to-be newlyweds join their finances.
"Tens of millions of families struggle to afford a car repair or dental treatment because they lack sufficient emergency savings," Stephen Brobeck, executive director of the Consumer Federation of America, said when releasing results from one of many surveys that show how poorly Americans save. The CFA study found that just 37 percent of low- and moderate-income families have a savings account. Of those who did, the median amount in it was less than $1,000.
Even parents, who are financially responsible for children, don't save well. Just 42 percent of parents maintain an emergency fund, according to a survey by financial firm T. Rowe Price.
It sounds so simple — put away some money for a rainy day. Yet so many people don't do it — perhaps because they don't have a good answer to a fundamental question: Why?
"Why should I leave cash sitting idle when there are so many things I need and want?" Or, "I could invest the money and earn far more than measly bank interest."
You only need one persuasive reason to start your own emergency fund, or add to an existing one. Maybe you'll find one here.
Avoid finance charges. Bad things — expensive bad things — happen, even to good people. Cars break down, roofs leak and teeth need crowns. If you have the cash to pay for life's curveballs, you'll avoid putting charges on a credit card and paying finance charges, or worse, taking a payday loan. If you can't pay the bill at all, it will likely go to collections and damage your credit rating, making borrowing more expensive for years after.
Lower insurance costs. If you have cash, you can choose higher insurance deductibles — the amount you pay before insurance kicks in — for auto and home policies, significantly and permanently lowering your annual insurance costs. Common advice is to increase your auto insurance deductible to $1,000 and raise your home deductible to $2,500.
Say no to extended warranties. Similar to insurance, having cash for repairs and replacements of appliances and gadgets allows you to forgo pricey extended warranties.
Job loss. A robust emergency fund can help compensate for losing a job, bridging the financial gap until you can get income flowing again.
Sense of control. Having a pile of cash can provide peace of mind and a feeling of control. Some of the worst money worries never materialize, but are conjured in our minds. Having even a few thousand dollars stashed away can relieve anxiety.
Irregular income. For those with up-and-down income — those paid on commission, for example — a cash cushion is necessary to even out high- and low-income months.
Give yourself options. If you have no money, perhaps you will decide against buying an airline ticket to visit a sick relative? Will you forgo an operation that could save your pet's life? With a little extra cash, you won't have to make money decisions you later end up regretting.
Taking my own advice
Fortunately for my family, my wife and I took the advice I dole out to readers about building a cash stash.
I won't call ours an emergency fund, because after a while we didn't view it strictly that way.
Instead, we viewed it as an opportunity fund.
My wife hit a roadblock for advancement at her workplace and wanted to take some time off, a mid-career hiatus.
We'd been building sizable cash savings for years. We surpassed the point at which we had enough to pay for life's unexpected expenses. But we kept adding to the fund, which at one point helped us pay cash for a one-year-old car. It also helped during a relocation cash squeeze, supplementing a down payment on a new home until the previous one sold.
We would tap the fund and build it again. Along the way, we enjoyed the ability to say no to extended warranties, pay less for insurance by taking high deductibles and never pay a finance charge on a credit card because a large expense arose. In that way, having the cash allowed us to make choices that made life cheaper.
Maybe most important, however, was the emotional freedom the fund provided. We got to the point where we viewed the cash as a "take this job and shove it" fund. If either of us got fed up at work, we could quit without immediately having a new job lined up. We didn't have to be trapped in work that made us miserable.
So, my wife quit her job. The emergency fund filled the income gaps of intermittent consulting work she was doing.
After 10 months out of work, she's rested, revitalized and ready to resume her career full-time.
For our family, our opportunity fund was a real example that money can, indeed, buy happiness.
Emergency fund frequently asked questions
Q. Who needs one?
Everyone whose life doesn't always go perfectly — which is to say, everyone.
Q. How much do I need?
Typical advice is cash equal to three to six months of bare-bones expenses — food, shelter and utilities. But that dollar figure can be overwhelming. Start with intermittent goals, such as $1,000, $2,500 or enough to pay four months of the mortgage or rent. The amount you ultimately need will depend on a variety of factors including whether you have a two-income household — if an emergency fund is to protect you from job loss, families with two earners are less likely to have all their income cut off.
Q. Where does it fall among money priorities?
It's a good idea to start with a small emergency fund, say $1,000 or 2 percent of gross household income. But then turn attention to high-interest debt, such as credit card balances, before returning to the goal of beefing up the emergency fund.
Q. Does it have to be in cash?
Preferably. Cash gives you the most options and is quickly available. But when trying to safeguard against job loss, which requires a much bigger fund, consider unused credit on credit cards, home-equity lines of credit (HELOC) and even potential borrowing from family.
Q. Where do I keep it?
Ideally, you would keep cash in a separate account. Consumer behavior studies show we're more likely to keep our hands off it for discretionary spending because of "mental accounting." We view that money as unavailable. Don't stress about earning decent interest on the money. Think of it more as insurance than an investment.
Q. Where do I get the money?
Fund it with automatic contributions — an electronic transfer from your checking account on pay day, for example. Also fund it with lump-sum windfalls, such as a portion of your income tax return.
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