When defining a banker Mark Twain said, “A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.” New Edition posed a thought provoking question in one of their hit records “Sunny days—everybody loves them but can you stand the rain?”
An emergency savings is known by many names—emergency fund, god only knows fund, hard times fund, in case something happens fund. The most popular name used to describe emergency savings is a raining day fund. An emergency savings is money set aside to help cover you and your family during unexpected events that result in a reduction or loss of income such as unemployment, disability, death, or divorce. An emergency savings can also be used to pay for unexpected expenses such as home and car repairs, legal fees and medical bills. When things happen that affects your money that are unplanned and unexpected it feels as if its raining on your parade. An emergency savings or raining day fund will serve as your umbrella shielding you from the rain.
In the event something unexpected and/or unplanned was to happen to you, do you have a raining day fund in place to help you weather the storm? According to a survey done by CNN, 41-percent of Americans don’t have an emergency fund.
“Ideally” an emergency fund should be 3 to 6 months of living expenses. However, “initially” 3 to 6 months of living expenses is simply not practical for the average person. Since I ascribe to pragmatism versus theory, my advice for building an emergency fund differs from conventional financial experts. Before I share my process for establishing an emergency fund, let me share some bad financial planning commonly used for an emergency fund:
•Credit Cards—One of the primary reasons people use cards is for emergencies. An emergency or unexpected expense and/or unexpected event usually results in a reduction of income and/or an increase in expenses. Accumulating more debt in the midst of a money crunch seems foolhardy to me.
•Early Withdrawal from Roth and/or Traditional IRA (Individual Retirement Account)—Only in a bankruptcy or foreclosure preventing situation would I consider the idea of making an early withdrawal from a retirement account. Call me old school, but shouldn’t a retirement savings serve its intended purpose—RETIREMENT. No wonder why 96 percent of Americans age 65 and older are dying and retiring broke. Without a solid financial game plan, they’re using their retirement accounts for emergencies, home purchases, car purchases, college funding, debt consolidations, etc. In other words they retire their retirement portfolio before they retire from work.
•Loans from a 401(k) plan or similar retirement account—People often rationalize that they’re paying themselves back at a low interest rate when they borrow from their 401(k) plan. When you’re investing money, you’re looking for the best rate of return with acceptable risk—not a low interest rate. Furthermore, the payments you’re making to your retirement plan hinder your ability to continue to save toward retirement. Your employer will not match the money you’re contributing as loan repayments so you lose the match. In the event you leave your employer or they politely encourage you to leave, your loan becomes due in full. If not paid in full, it’s treated as an early withdrawal. Therefore, you may incur a 10 percent penalty.
•Cash value in a life insurance policy—A life insurance policy with a cash value element is the most aggressively sold life insurance product. In my opinion it’s also the worst. In the event you have cash value life insurance and you use the cash build up to provide the needed cash for your emergency, the money withdrawn from the cash value will reduce the death benefit. Most people who have a cash-value life insurance policy are already underinsured.
Unlike the traditional financial advice you hear, save a little here, invest a little here, and use what’s left for debt reduction, I use a more F.O.C.U.S approach—Following One Course Until Successful. I have a three tier emergency fund saving process. The first tier is to free up a minimum of 10-percent of your gross household income. The money freed up here will have a very focused purpose. Its first purpose will be to save $1,000 as a minor emergency fund. Initially, it’s more realistic for most families to save $1,000 as a minor emergency fund. After we have $1,000 saved for minor emergencies, we’ll then use the 10-percent or more we freed up to accelerate our debt reduction plan. Now that we have paid off all debt except for the mortgage, we have effectively increased our cash flow. It’s now realistic to save a fully funded emergency fund of 3 to 6 months of living expenses in a reasonable amount of time. I also have a three-line defense when faced with an emergency—(1) Do without, (2) Use the money we freed up to address the emergency, (3) Tap into the emergency fund.
An emergency fund should be placed in a simple conservative easily accessible account such as a savings account, money market account, or money market mutual funds. With an emergency fund, you’re not concerned about rate of return. You’re concerned with preservation of principal. You want to be sure that in case of an emergency, you can break the glass and access the necessary funds.
(Damon Carr can be reached at 412-856-1183.)