Emergency Fund: Rules of Thumb vs. Reality - By Chris Cushman
An important way to prevent credit card debt is to keep some money available to covered life’s unexpected emergencies. Do you have enough? Or too much? How do these rules of thumb apply to you?
- Amount – (RULE) Set aside 3 to 6 months of expenses. (REALITY) What do you count as an emergency? The two most expensive surprises people can’t predict seem to be job loss and medical related expenses. How long would it take you to get a job and how long would it take to support yourself (and family) during the process? How is your health coverage? These two factors need to be considered as a personal baseline. Most people don’t plan for things breaking (like their car or home) although you know that eventually things break! Plan ahead! Roof, AC Unit, appliances, tires, engines, etc. Calculate replacement values for everything that’s wearing out and save for these items. I prefer separate accounts so you can track how you’re doing, but the key is save consistently for everything.
- Location – (RULE) Keep emergency funds in a safe, liquid account. (REALITY) The most important factor is having the money when you need it. If you invest the money and need it while the investment is down 30%, would you be in trouble?? Low interest rates are pushing people to invest differently. Keep at least some money in a savings account. I prefer multiple savings accounts that you can label with the specific savings goal/use. Consider this: stock markets generally decline as unemployment rises. This correlation could hurt you if unemployment hits you during a recession. Let the safety of your cash reserve allow you to take investment risk elsewhere. If the temptation is too high then only invest some of the cash, while keeping most in more stable places like savings accounts and short-term CDs.
- Debt – (RULE) What if you’re already in credit card debt? Pay it off. (REALITY) It never makes sense to save and make 1% interest when debt is costing you 20%. The issue generally comes down to lifestyle. People don’t realize that they need to decrease expenses (or increase income) enough to pay down debt and account for emergencies. This can be painful and the habit is hard to build. Determine what needs to be replaced over the next 3 years and incorporate this into your debt pay down strategy. If you only have longer-term, lower interest debt like your mortgage, then a cash reserve is vitally important.
Emergency needs are highly specific to every family. Call us soon and we can help you make wise choices!