Monthly Archives: May 2007

Contemplating Risks when setting up Emergency Fund

One of the things that many people do not do when considering their emergency fund is how much risk they have. They may have thought of the chances of being laid off from their job in determining how much to save, yet typically nothing more. We have relied on the rule of thumb of having 3 to 9 months set aside for an emergency fund. However, we never really thought if 3 to 9 months is really enough for what an emergency fund should cover.

Some of the risks that we should consider for an emergency fund are:

Age – The chances of being disabled increases with age. Also, even though age discrimination is not permitted, it is sometimes more difficult for older workers to get hired for certain jobs if they find themselves unemployed. It may not be age discrimination necessarily; however, an employer may use potential to decide which of two equally qualified applicants to hire. If one applicant’s potential may not been fully realized where the other applicant with more experience may have shown his full potential already (given more chances to succeed yet has not done so), the one with more potential may be given the nod. If a company had too many employees with no potential for growth, they are stuck in the mud because it is hard to promote within. Contrary to what we think, companies want to promote within because they have seen their employees in action and it is risky to hire someone based on a resume and short interview process. Thus, the potential for future growth is sometimes given preferential treatment over experience in the hiring process especially in lower and middle level positions.

Education – The probability of being unemployed at a point in time being a college graduate is ½ the risk of a high school graduate (per College Board – 5.4% for high school graduates versus 2.3% for college graduates). Sometimes having a college education gets someone in the door even if their degree has nothing to do with the job criteria. Some employers may see the college degree as a sign of determination and ability to learn on the job and thus give college graduates preferential treatment in the hiring process.

Job Skills – The more flexible your skills are, the more opportunities you have to switch careers. If you are a pianist who is starting to develop arthritis, it is hard to transfer your skills other professions other than being a piano teacher. The skills I used as an actuary in a consulting field has allowed me to do many different things down the road because I did a little bit of everything as an actuary from accounting, economics, investing, legal, speaking, etc. as a part of my job. Thus, the more skills you have, the more opportunities you have open up if you need to change careers. In today’s world, many people will have more than one career thus flexibility is a key to reduce risks of being unemployed.

Job Market – If you are a nurse in today’s economy, it is easier to find another job than some other professions. For example, if you work in the car manufacturing field, the opportunities are more limited where changing jobs if you are laid off it much tougher and may take a longer time to find another job. Therefore, you may want to have a larger emergency fund.

Economy – Many people think when the economy is booming that there is little need to have a large emergency fund because they could always get another job easily. However, the economy tends to change with little warning. With companies being more careful about watching costs, they can turn their hiring forecasts around within the matter of months. Thus, even if the job outlook is great now, in 6 months it can easily change.

Living Expenses – If you have a lot of fixed expenses (mortgages, car loans, cell phone contracts) where it is hard to cut anything, you are at greater risk than someone who has mostly fixed expenses that can be cut instantly (like vacations, eating out, entertainment, etc.). The more we can and are willing to cut the less of an emergency fund we may need.

Insurance (Disability & Medical) – We know about the risks of becoming disabled and not being able to work as a reason we need an emergency fund. Just realize that even if you have a good long-term disability insurance polity, the policy will typically not cover 100% of your lost income (typically 60% to 80% of base income) because if they did there would be no incentive to go back to work. Also, needing an emergency fund to pay large medical expenses is also important. Thus, if you have a plan that has high deductibles and no cap on co-pays (e.g. 20% on all expenses even above $5,000), you may need to have a larger emergency fund in case of an accident or illness.

Also, everyone talks about 3 to 9 months of living expenses and thinks about their current expenses. However, what many people forget about is covering the cost of COBRA (health insurance) while unemployed. Many are unaware of the cost until their ex-employer offers to continue their medical insurance at 102% of the actual cost to the company (cost of insurance plus 2% for administration expenses). This is significant because many of us do not even consider the part of our health insurance that we already pay because it is taken automatically out of our paycheck. I have heard too many people say that they were not able to pay for health insurance, so they went without insurance and are now struggling with debt due to having a medical condition diagnosed in the meantime. If you are unsure how much health insurance will cost to cover your family, many employers are listing the full cost in their annual benefit election material or their annual summary of benefits. If it is not there, you can always ask your HR representative.

Family Situation (changes like having a baby) – Many people do not think ahead of some additional expenses that they may have when having a baby. We think about the cost of getting the car seat and baby furniture. However, many do not factor in if there are complications with the delivery. Not only could they have significant medical costs but also they could have a loss of income due to being confined to extended bed rest or needing to be in the hospital with their baby after a premature delivery or other complications. Many first time parents spend more time thinking about taking their last vacation BC (before children) than thinking about saving a little bit more just in case something happens. The unexpected costs are not only with children but also with elderly parents where adult children may need to take off for an extended period of time to take care of the parents or pay for a nursing home.

Single Income – Some feel that it is more risky being a dual income family than a single income family because if one spouse is laid off or become disabled in a single income home, the other spouse could go back to work. This may or may not be true depending on their spouse’s employment background. A spouse that stays at home to raise their children may be out of the workforce for a long period of time that it takes a while to get back into the workforce and when they do it is usually at an entry level especially after a prolong break (needing to prove their abilities all over again). Thus, it is true that there may be some reduction in risk because the other spouse can re-enter the workforce to replace the single earner’s salary. Yet, it is probably going to be at a fraction of pay and may take weeks and maybe months to happen. Thus, sometimes there is less of a risk being a dual income family because you may lose 50% of the total family income, yet it is better than 75% reduction of a single income family’s income, especially if the spouse working has a high paying job (such as a manager or physician) compared to the spouse who goes back to work to fill in the gap. In addition, dual income workers, tend to have higher flexible expenses such as eating out, dry cleaning, maid services, etc. that can be cut back on if one spouse now is temporarily at home and has more time to do these chores instead of hiring someone else to do it for them.

Medical History – If you are not as healthy as others or your family history shows some tendency for a medical condition (such as heart condition or cancer), you may want to be better prepared in case something happens.

Paid by Commission instead of Salary – If you are paid by commission, it is better to have a larger emergency fund in case there is a drop off in sales due to a cooling economy or a new product that enters the market place and takes away some of your business.

Self-employed – Some say that being self-employed is less risky than being employed by a company where you are at risk of being fired. However, in my mind being self-employed is riskier because you are still at risk of getting fired by your clients (instead of by a company). Yet, at a company, if you are fired, you can claim unemployment, something that is not the case if you are self-employed (can’t fire yourself). In addition, being self-employed, you ride the waves of clients coming and going (similar to being paid on a commission basis). In being employed by a company on a salary, the company insulates you to an extent by providing a fixed income. In addition, if you are better than the average employee, you are a somewhat insulated from being fired at the first signs of a business downturn (unlike being self-employed).

Thus, when you are considering how much to save in an emergency fund, look at all your risks, not just the chance of being unemployed. Those who are better prepared in an emergency have a better chance at getting out quicker because they can focus on the problem and not trying to scramble for cash to pay the bills.

Have a Happy Memorial Day

I just wanted to wish all my loyal readers a happy Memorial Day weekend. I will be spending mine with my in-laws celebrating my son’s second birthday.

And, as we are traveling, let’s pay attention to how many people are on the roads. The news here in Cleveland has been focused on how consumers are going to continue there driving habits even if gas prices go higher (even up to $4 and beyond). It has even been suggested that our thirst for gas will not be quenched until the regular non-SUV driver pays over $100 to fill his tank. Thus, the news is still expecting a booming holiday travel weekend.

I bring this up because we all hate how high the gas prices are going. Yet, we seem to be doing little to nothing about it this time around, other than demand Congress to investigate the oil companies. Congress battling the oil companies has been attempted several times in the past with no impact on the gas companies or the price of gas. Some will blame Bush and Cheney. Yet, to prove price fixing, it takes a lot of evidence which is not available (if price fixing is even going on). And, complaining about this issue has done nothing to lead Congress and oil companies to find a solution to the problem like agree on EPA regulations changes to get a few additional refineries built ASAP to make up for the lack of supply on the market or require an increase in the fuel efficiency standards for new cars.

The first time gas spiked over $3 a gallon at the time of Katrina was right before Labor Day weekend in 2005. At that time, I noticed how barren the drive from Cleveland to Chicago and back seemed to be for a holiday weekend. It appeared that because the price of gas increased so rapidly, many people choose to stay close to home to conserve gas and their money. Thus, the price of gas came down soon thereafter even with all the refinery issues. However, this time, it seems that because the price increased on a slower pace where consumers feel that nothing can be done (I have seen several drivers interviewed on the news saying what can they do, nothing but pay the prices). Thus, because demand is not changing, the price continues to increase. This is similar to a frog’s reaction to a boiling pot of water. If the frog is put into a pot of hot water, the frog will take immediate action to get out. If the frog is put into a pot of cool water which is then heated, the frog will stay in no matter how hot the water becomes (or high gas prices go).

Note, consumers have the most power to influence the price of gas. It is all in our choice on how much traveling we want to do and in what kind of cars we drive. We have tended to want bigger cars for the power and safety features that the car has. We made a push in early 2006 for smaller hybrid cars after the spike of gas prices from Katrina. Yet, as price of gas decreased from consumers rethinking their choices (and no hurricanes hitting the Gulf Coast last fall), we have became complacent and have gone back to our motto bigger is better. Well, it has caught up to us again. Until we choose to affect the long-term demand for gas we will continue to fight the high price of gas. So, as you travel this weekend, just notice how many people are on the roads. There is nothing wrong with wanting to travel; we just need to be aware how each of our choices is affecting the price of gas.

There are several things that we can each do to have an impact, including making sure our tires are properly inflated, driving the speed limit and buying more efficient cars. I find it interesting that people buy SUVs for their safety yet speed putting themselves and their precious passengers at higher risk of an accident.

Footnote – just as I am publishing this, ABC News came out with a survey that 3 out of 10 families are planning on not taking a summer driving vacation due to the price of gas. I do not know if these 3 families who changed their plans were the families who usually stay close to home anyways and thus were not really serious about a vacation anyways. Or, if these families were planning a trip like they have taken in the past and cancelled their plans, indicating a deviation from past practices. We will see how consumers respond. For my wife and I, we have not changed our driving habits as of yet. However, when we bought my wife’s car in Fall 2005, we choose a Subaru station wagon over a SUV due to the gas mileage.

Eating Right, Professional Athletes & Financial Prosperity

I was watching the end of a baseball game last week and after the game, they were interviewing a player about how he keeps in shape during the season. He was talking about how he needed to lay off the fried foods that he loved during the season because the foods adversely his energy level during the games. Professional athletes have been paying more attention to what they eat over the last 20 years because they know that if they are not in the peak physical shape, they will lose their paycheck. Gone are the days where “Refrigerator” Perry could eat anything he wanted and be a star football player for the Chicago Bears. Now, there is a lot more attention even during the off season on an athlete’s diet and exercise program because they see the relationship between their energy level and their pay check.

So what does this have to do with personal finance? We are not professional athletes, so is diet that important to our paycheck? Absolutely, we may not need to run 100 yards for a touchdown or 20 yards to make a diving catch for a baseball, yet how we perform during the day at work is as important to our paycheck as how an athlete performs on the field. However, many people do not think twice before eating a greasy hamburger with extra large fries that will hit the pit of their stomach during the afternoon making them want to take a nap.

We want to blame the long day at the office for not being able to concentrate after work on things that can improve our job outlook like reading the training materials our boss gave us 3 months ago instead of looking at what we eat. I know at my last job, my boss gave me a training binder for improving my consulting skills that he wanted me to read over and discuss with him. However, I never seemed to find the time or energy to read it because I was too tired at the end of the day to pick it up.

Over the last few months, I have also been noticing my energy levels. When I have ice cream or pie for dessert at lunch, I know that I will want to take a nap around 3 or 4 o’clock. And, because my son does not let me do that, I am dragging until 7 o’clock until the sugar fix has passed. When I do not exercise in the morning, I know that I am more irritable and lack energy to work on my writing projects than if I get in 2-3 workouts a week, even if it is just a walk around the block.

So it is important to look at when we are most productive during the day. For me it is in the morning after eating a health breakfast (cereal and juice). Yet, I tend to drag in the later afternoon especially after eating french fries. By seeing our patterns we can correlate to see how what we eats affects our productivity. Also, look we need to understand how if we increased your productivity either in the sluggish morning or afternoon, what it can give us. By being more productive, we may be able to avoid coming into work on the weekend (or stay late) and thus be away from our families less. Or by being more productive, we can get that next promotion. Or, we can work on an idea for a new business after we are done with work because we are more energized.

Thus, when we are looking at ways we can increase our financial abundance, we should look at what we eat and how we exercise. By watching what we eat not only can we cut back on our expenses that we spend on unhealthy snacks but also we can increase our performance at work which can have a direct link to the paycheck we receive (or do not receive if we were caught napping at our desk too many times).

Emergency Fund – Changing Your Behavior

We all know that we should have an emergency fund in place to help deal with unforeseen circumstances that happen in life. By being prepared ahead of time, we are better able to avoid taking on a large amount of unexpected debt. Yet, an emergency fund does more than prepare you for unforeseen circumstances; it also helps to change your behavior as well. When living paycheck-to-paycheck for an extended period of time, sometimes changing our behaviors/habits are just as important has having some money saved up in the bank. For example, when setting up an emergency fund, we tend to

Be Forward Thinking

In living paycheck to paycheck, we tend to be thinking just about how to make it through the end of each month. Our thinking is very short-term, specifically on what we can do to survive our financial struggle. It is a continual process of putting out fires where we have no energy to concentrate on the long-term that we need to get out of our situation.

With an emergency fund, our needs for the month are taken care of. Thus, we can start looking forward to the future. When our focus is on short-term survival, we stay stuck in the struggle because we can not see far enough out to avoid the financial pitfalls before they occur. When we look long-term, we can start avoiding issues before they become a fire that needs to be put out. We can see where the long-term issues are and start making adjustments accordingly. In management training, the discuss things we do each day that are graded on urgency and impact. We tend to spend a lot of our typical day on urgent things that are important (emergencies). However, to be effective, we need to plan ahead and spend more time in non-urgent activities that are important to avoid them becoming emergencies. Thus, the more we plan ahead the better off we are.

Be Understanding of Our Risks

One of the misconceptions of an emergency fund is that it should be a fixed number of months of living expenses (being 3 to 9 months depending on which financial advisor you are talking to). This general rule of thumb is meant to get people to put money away. Yet, to optimize your emergency fund, we need to better understand our risks. If we have higher risks (e.g., older, have medical plan with higher co-pays and deductibles, no disability insurance, etc.), we may want to have a significant emergency fund because we have a higher likelihood of needing it long-term. Thus, there is not a specific target that we should have because it is dependent on the risks we have.

By seeing what we need for an emergency based on our risks, we are better able to manage our behaviors day-to-day to reduce our overall risk. For example, if we work in a shrinking employment field (e.g., manufacturing), we may need to look out for other opportunities to keep our resume up to-date and find ways to expand our employment opportunities (through training and/or seeking out new job). Maybe we can to switch fields to become a car mechanic instead of building cars especially if we know the plant we work in may be shutting down in a few years.

There are risks with personal finance. However, when we are aware of our risks, we can better manage them by adapting our behaviors accordingly. Maybe we save more money when our job or our health is at risk. Maybe we increase our networking efforts, when we feel our job at risk. Whatever it is, the more we know about our risks and look forward to what may be a problem down the road, the better prepared we will be to deal with the situation.

Have Other Savings

I have seen situations where people have not been able to save money of any significance for most of the adult life (20 or more years). They have gotten into a pattern of spending everything that they have. For some, this may be tied to a belief in the phrase “easy come, easy go”. Their spending habits (anti-savings habits) may be due to anytime that they have had some money saved up, they have seen something happen (like a car breaking down, tax payment comes due, etc.) that has wiped out their savings. Thus, they subconsciously believe that they should spend the money before the next bill collector comes a calling. Their belief is that they should enjoy their money before someone else takes it first because someone else will take it if they do not spend it first.

A well funded emergency fund helps people get over the inertia of having savings. Just like an airplane spends more energy trying to take off the ground to overcome the initial inertia of gravity, so does it take some extra effort to save money at first when you are not use to saving. Yet, once you see that saving money is possible via an emergency fund, savings behavior can be carried forward to saving for retirement as well. If we only save up $500 to $2,500 (one to two months of living expenses), something is more likely to come up to wipe it out, proving our miss belief that we are unable to save. If we save up, an adequate emergency fund (6 to 9 months), then we can handle the little bumps in the road and retain our savings showing us that we can get ahead of the game with a little diligence and effort.

Be Empowered

Having an emergency fund is shifting from being a victim to being empowered. When there is no savings, it is hard to see all the choices that we have because we are just concentrating on paying the next bill. When something happens, we see very little that we can do about it because we are scrambling to find any way to pay the bills.

By having an emergency fund, we are in more control of what we can do when something unforeseen happens. We can see our choices because we have time to react to how we are going to pay the bill because we always have a fall back plan (using the emergency fund). The key thing is that when we feel that we have more control of a situation, we are able to see more opportunities. When we are able to see more opportunities, we can find alternative ways to pay for bills rather than being a victim to sales agents or payday loan firms.

For example, if our car all of a sudden breaks down and it can not be repaired, someone with no emergency fund will be more desperate and go out and take what ever offer is being provided. It is a recipe for being taken advantage of especially if the car dealership senses our desperation. Someone who had an adequate emergency may be in a similar position (a bit desperate for wheels). Yet, they have the option of renting a car for a week to look for a better deal especially if it means saving $1,000 or more off the price of the car by not being as desperate. Or, they are able to look around to find the perfect used car rather than taking the first car they see because they have no money to take off of work to look for a car that may save them $5,000 by shopping around.

We always think that money is the solution to all our financial problems. However, it is our behaviors that have more of a long-term impact on our financial situation. By moving forward to set up an emergency fund, we are not only putting aside money that we may need later but more importantly setting up better financial habits that will pay larger long-term dividends. Setting up an emergency fund is a step towards being empowered to save for retirement and a step towards being a better negotiator by having all our options at our disposal instead of making quick decisions because we are running around putting out fires.

Simplify Our Finances – Long-Term Focus

I have never been a supporter of the “ask for a raise” fad. In previous articles, I have written about asking for a pay raise discussion instead. “Asking for a raise” is sometimes a knee jerk reaction that can lead us off course from our actual goals. Our ultimate goal is probably working in a long-term well-paid job that we enjoy. We think that a raise will increase our pay long-term, yet it is normally the raise is just a 1 to 3 year adjustment unless we adjust our responsibilities accordingly to compensate for the increased pay. This is because if you get a better than expected raise in year 1, the other years will probably be lower than expected to get you back in line with everyone else unless your responsibilities changed. Thus, when you hear that someone got a 20% or more raise, look at what responsibilities they have taken on over the last year or two or what responsibilities they will take on in the next year. Articles imply that people ask and get these raises all the time without doing anything special. I have a hard time believing that a 20% raise is frequently given without one of three things happening:

• The person took on more responsibility over the last few years and the boss was already working on the pay raise

• The raise came with a promotion where more is expected out of the employee in the future

• The boss gave in because he was in a pinch (did not want to lose the employee just yet) and will be looking to never get pinched again (e.g., find someone else in a reasonable pay range to replace the employee with).

A company usually has well defined pay ranges that most if not all of their employees fall into. Only the star employees will end up on the higher end of the pay scale long-term.

I am a big believer in having pay raise discussions with your boss because what he is willing to pay is determined based on criteria that he finds valuable. By understanding these criteria better, you are better able to direct there focus on the issues that will be thought of when the next round of pay raises are give. In my opinion it is better to have a longer-term focus where the 20% pay raise is not the goal rather the goal is receiving steady 4% to 7% raises as you advance through the organization for 20+ years.

By showing your employer that you are willing to work with him long-term, he is also more likely to remember this when he needs to decide who is a team player that he wants to keep if/when he is forced to let people go. If he needs to cut costs, who is more likely to be let go? Someone who priced themselves out of his pay structure or someone who worked his way up by taking on more responsibilities to justify his higher wages.

Long-term expenses

I look at the current mortgage issues as the perfect example of short-term focus. We have been told throughout the years that owning a home is much better than renting. As people tried to correct this issue and become homeowners, some focused on short-term and looked for a home and mortgage that they could afford at that time, even if it meant that they had to take on an ARM (adjustable rate mortgage) to do it. They saw the prices of homes skyrocketing and did not want to be left behind. Unfortunately some buyers only considered their short-term issues (e.g., their down payment and mortgage payment), figuring their long-term finances would take care of it self with raises and promotions. They were caught short when interest rates increased leaving them with significantly higher mortgages. If asked ahead of time, some of these people would have probably decided to rent if they saw how much they could be paying after a few years when the initial interest rate on their loans would be adjusted. Now, we can say hindsight is 20/20 and people would not have chosen the mortgage they did then based on what they knew at that time. Yet, some of this hindsight could have been foresight by looking long-term.

Long-term focus is also about saving ahead of time for things that you want like a home and a car. Now, I am not saying to avoid taking out loans when needed. Rather, instead of jumping up to a $500 car payment, work up to that amount by saving $250 or more towards your new car. This way, you have some savings that can go to a down payment. In addition, you have not created a situation where if you were living paycheck to paycheck, you all of a sudden will need to cut back $500 in spending to squeeze in the new car payment. So map out the large changes in your expenses for next 5 to 10 years (especially if you have children or want children) to see if there are going to be large changes that you should be considering and planning for now.

The other issue is looking ahead to plan for an emergency plan. If you are driving and the car ahead of you is driving erratically, you would start planning what to do to avoid the car if circumstances warrant it. Maybe you consider swerving into the next lane or maybe you can slam on the brakes (if no one is tailgating you) if something happens. You may even consider driving slower to let the car get a safe distance ahead of you. We need the same long-term focus in our finances instead of waiting until the last minute to decide what to do to avoid a financial crash. Having a long-term focus by having an emergency plan would save many people from getting into a financial accident that they did not see coming.

Investing

One of the most common investing mistakes made is buying high and selling low. In trying to avoid large investment losses, we watch the stock market and to see if we can time it. Thus, when the stock market starts to fall, some people jump out of it to avoid losing even more money. However, there is a tendency of selling closer to the end of the market downturn and waiting too long before getting back into the market. The amount of money invested in mutual funds approach record levels during a bull market (when market is rising) and fall during bear markets because everyone wants to get in when the going is good and flee when there is some tough times. Many people though loss out on potential returns by being too cute with their investing strategy and end up selling and buying too late into the cyclical cycles of the stock market.

Taking a long-term horizon to investing will help in avoiding these mistakes. And, will make your life calmer by avoiding the agony of watching the daily changes of the market. Remember, earlier this year, the market had several days of large losses (in late February to early March of 2007) where some people where wondering if it was the start of a bear market only to have the markets rebound to record highs now in May. No one knows what will be happening with the stock market. As I told my clients, if I knew for sure what was going to happen, I would be sitting on a beach in Hawaii rather than sitting in a meeting.

Investing long-term will also free up more of your time for more important things in life. Why worry about a bad month in the market when you are invested for 10 years or more time horizon? And, if you are invested in the short-term (a few months out), then you may want to avoid investing in stocks due to its volatility.

Conclusion

It may seem so simple to say to look long-term to solve some of your financial problems. Yet, sometimes it is the little things that we do that can make large impact on situation. Even in situations where people are in debt, looking long-term gets them focused on a goal of being debt free (or other saving goals). Having a long-term focus does not mean you do not need to pay attention to getting out of your situation. Rather long-term focus means looking out into the future so that you are focused on where you are going rather than where you have been. When we focus on where we have been, we remain tied to it because we are so discouraged that we have less energy to get out of it. Moving towards a long-term goal is better than lamenting over where you are because the act of moving forward starts the ball rolling to where you want to go.

In management, I learned that responding to crisis will keep you busy all the time while planning for the long-term helps you get out of things becoming a crisis. When you are in a crisis, you need to spending time doing a little of both. The key is to start looking towards the long-term so that you get out of the trap that the crisis is keeping you in.

Emergency Fund Q&A (Part I)

Purpose of an emergency fund

Why should we have an emergency fund?

When there is a true emergency like having a child in the emergency room or being laid off from work, the last thing you want to worry about is where the money is going to come from. The more your finances are taken care of; the more energy and focus you have for what is really needed (e.g., getting a job or taking care of your child). For me, the peace of mind is well worth the effort of setting aside a little money ahead of time.

What constitutes an emergency?

Some would say that an emergency is anything that is not planned for in a budget like replacing a dishwasher that breaks down or needing to repair the roof of your house. Some may even use it to cover themselves during a slow time in their business, whether they are self-employed or a substitute teacher during their slow time in the summer.

I tend to promote a stricter definition of emergency. For me, an emergency is something that can not be reasonably planned for. Thus, repairs to a dishwasher or roof should be planned for because we know we need to replace them after so many years (10 to 25 years). By planning ahead things tend not to be emergencies. We may not have built up an adequate repair fund if we targeted to repair the roof in 20 years and we need to replace it after 10 years. However, we would have at least ½ of the money in our repair fund thus we would not need to rely on the emergency fund as much.

Why should the repair fund and emergency fund be separate?

There are many reasons in my mind. The key is if we just replaced the roof where we used ½ of our emergency fund for the repair, what kind of pickle would we be in if we had a true emergency just after we wrote the check for the roof? For some people $5,000 is a lot of money to have saved. And, if ½ of it goes for repairs, it would barely leave enough money to survive a couple months let alone the recommended 3-9 months for an emergency fund.

Also, when we have one fund that is grouped (emergency and repair fund), we have a tendency to under fund it. We may feel that funding by $3,000 a year is adequate. However, if our normal repairs on a house and cars may be $2,500, only $500 would be going to our emergency fund. People then wonder why after several years they just can not seem to get their emergency fund up to what they were targeting. In my mind, it is better to factor in your repair fund separately at $2,500 and then target how quickly you want to build up your emergency fund. Funding your emergency fund may require it to be $2,000 a year thus after 5 years it is up to $10,000 instead of saving just $2,500 (in the combined fund where we were saving just $500 a year). Saving $2,000 a year (to get an adequate emergency fund) will take a conscious effort so it is important to know your target and plan on it than saving what ever is left over at the end of the month.

How should an emergency fund be invested?

What types of fund should I invest in?

The key factors are (i) preserve the principle and (ii) be able to withdrawal funds in a timely fashion.

Being able to withdrawal funds quickly may not be as important as it once was. With many services taking credit cards these days, many times we do not need access to the funds within 24 hours if we have a credit card with an adequate balance available. However you do not want to have the fund tied up in an investment were it would take weeks or months to get access to your money (like real estate).

The key is to make sure that the principle is safe and secure (e.g., in a FDIC insured account). Most people would advice using a high-yield savings/money market account for an emergency fund. Using the stock market to invest an emergency fund is usually not recommended because an emergency may occur during an economic down turn when stock market is down. What would happen if another 9/11 occurs? The stock market may loss 10% to 20% or more of its value just as your employer has to lay off employees to save costs.

What about investing in ladder-CDs?

Some people use this approach because CDs may provide a higher return than a high-yield savings plan. However, the two key principles need to be thought about. First, what, if any, early withdrawal penalties will you be required to pay if you have an emergency? People think the primary cause of an emergency is due to being laid off or disabled and needing cash for monthly expenses. Thus, having a ladder-CD (a plan where the maturity dates of CDs are spaced out so that a CD comes due every few months to pay the bills that you will need to pay for monthly living expenses) would accomplish the purpose of an emergency fund. However, an emergency can have bills come due all at once (like a medical emergency) where the ladder-CD would need to be cashed out early. In this case, many CDs would withhold a penalty for early withdrawal (could wipe out any savings that you get for the potential higher return on CDs). Second question to ask is how quickly will the financial institution cash out the CDs. Usually, it should be within a few days, yet make sure before jumping in.

For me, I choose to use a high-yield savings account due to the easy access to the funds on short notice. I find the better returns on CDs (after-taxes) currently are not worth my time and effort to maintain it.

Why do some people invest their emergency fund in stocks?

Some people who are risk takers, find the potential annual return on stocks (8-10%) too appealing to give up. For them, the potential return of stocks compared to the 2% to 4% return on their saving accounts outweighs any risks of selling during an economic downturn. They say that after 3 to 4 years getting 8% return on stocks (on average) would outperform the 2%-4% return on savings account even if they need to sell after a 20% drop in the market. For example, after 4 years the stock market could possibly return 36% (8% return). Even if the stock market drops 20% before they sell their stock for an emergency, they are still up 16% which would be equivalent or slightly better than having it invested in a savings account. And, if they can invest for a longer period (6 to 8 or more years) before an emergency or did not have such a downturn in the stock market before selling, then they would come out ahead.

This is true, yet no one can predict what happens in the stock market. If the stock market totally collapses (like during the Great Depression), then those invested in a FDIC savings account would have been glad for the meager 2% to 4% return. Plus, if the emergency happened early on (within a year or two), the stock market return can easily be down where the loss of principle happens at the worst possible time.

What about a home equity line of credit?

Some people are using a home equity line of credit to use in case of an emergency. The purpose of having a home equity line of credit is if they need money, they can borrow against their house if they do not have the money saved up in a savings account. The key is to have the line of credit in place before an emergency because it is harder to get a loan if you are unemployed.

It is important though to know the cost of setting it up (e.g. application fee and closing costs) and using it (e.g., interest rate charged). For more information see home equity loans from Federal Reserve. Two other important issues to think about is the terms that you will need to pay the loan back. If you take out the loan, you may need to start repaying it back immediately. Thus, you may want to plan on needing a higher loan amount available because if you are unemployed and can not pay it back immediately a little extra money will come in handy to avoid missing required payments on the loan. Second, a home equity line of credit can be dangerous compared to other loans because the bank can start foreclosure proceedings if you default on your loan because the loan is backed by your home. For unsecured loans (like credit cards), they can take you to court if you default on your debt and put a lien on your home, yet they can not foreclose on your home at that time.

Simplify Our Finances

I plan on writing a series of articles on simplifying our finances. I see these articles as a way to focus our attention on the little things that we can do no that will have a big impact on our financial health and personal life. I am not talking about saving $1 day stuff that will get you to be a millionaire because these are small steps to trim some fat in your spending. Yet, once the fat is trimmed what else is there? Plus, a lot of this has already been covered by others. Rather, I am looking more specifically at how we use money and that with a little focus can have a major impact on how we live. I will be looking at how a small change now can lead to $1,000s of dollars saved each year. My philosophy is that we can get more bang for the buck by looking at how we handle our finances than looking for the next financial trick to become a millionaire which usually focus on cutting spending.

One of the reasons that I am writing this is that personal finance seems to be getting to be a full-time job of tracking our budget, watching our investments, cutting coupons, etc., which is great yet time consuming. Thus, the key is to find how we can put our finances more on autopilot so that we are not a slave to money rather having money work for us.

The first step is to take a step back and see where we can have the most impact on our finances. A few areas are:

Income – For most of us, we will have over 30 years of working (if not close to 40 years). Most advice is to focus on getting a raise this year. The premise is that a raise will give you extra money for several years to come. However, raises have a trend to even out over time (great year one year may lead to smaller raises in the future). Also, a raise may put you out on a limb (increased probability of being fired) if your future performance does not live up to the increased expectations. Rather than focusing on this year, the focus should be on having a pay discussion with your boss to see what you need to do to be more valuable to your company.

Spending – For some, looking at the little things may be a good place to look to trim some fat. For others, there are little if any small items that can be cut. Many times we look for the little things to cut because this is where we have flexibility in the budget because everything else is locked in (mortgage, car payment, etc.). However, the biggest impact on spending is in our larger contracts (rent/mortgage, transportation, debt repayment, etc.). By looking at some of these amounts before we lock them in, we can have a larger effect on spending than cutting out a latte that we buy every couple of days.

Retirement – We work hard so that we can sit back and enjoy retirement. Thus, we work 30+ years, so we can relax the last 20+ years in retirement wondering (stressing) if we have enough money in case we live past 85 years old (possibly 90 or 100 years old). Thus, we work even harder to save more money to make it last 30+ years (to age 95 or longer). The stress of working drives us to want to retire earlier than we expected to because we can not take it anymore. It is like a catch-22. The harder we work to secure our retirement, the earlier we want to retire because of the stress. I have been starting to advocate working a part-time work in retirement. With the decline of company pension plans (providing a monthly benefit), it is more difficult harder to cover the risk of out living our retirement savings (living on withdrawals from a 401(k) account). The option of working on a part time basis helps because if we are healthy, we are more likely to live longer and need additional money from working. If we are no longer able to work, our life expectancy is probably shorter due to not being as healthy thus lessening the need of additional money from working in retirement. Thus, even if we can not work in our current profession on a part-time basis in retirement, we can see how we can use our skill in a different profession to help secure our retirement.

Investing – We spend a lot of time trying to research the markets to find out where we can find the best savings account and best stocks to invest in. We eagerly await our issue of Smart Money, Money, Fortune, Forbes etc. to find their suggested “can’t miss” stocks. We read how their picks from last year beat the market. Thus, we eagerly jump in and out of stocks based on their recommendations which can take several hours of research a month if not each week to keep up with the latest news. Thus, money becomes a full-time job that keeps us busy. Yet, what does it get us? Do these picks really outperform the market? Or, do we just hear about the picks that do (and those that do not are not reported)? What about the studies that show that a passive index fund usually beats out many active management funds after reflecting the management fees? Are they wrong if all these managers can outperform the market? So, is the extra time worth the effort? For some people, it is fun to research stocks thus is not a big issue for them to spend their time on their hobby. For others, it is a chore to keep up with everything to make sure they time the market right (if it is even possible) and they rather avoid it by using passive index funds.

Opportunities – We tend to stretch ourselves to the limit with both time and money. Have you ever had times where you have seen a great opportunity only to not be able to pull the trigger on it because you are already stretched too thin? There are times where we are so busy that we do not see the opportunities even if they are in front of our faces. Thus, we keep on muddling through our current circumstances and let opportunities pass us by. Having some flexibility with our time and money is important to be able to take advantage of these opportunities that can propel us to a higher level.

Over the next few months, I will look at each of these topics and others in more details to see how we can simplify our finances. Simplifying does not mean to live on less rather how to find ways to do less and get similar results. We have grown up with the idea of extra work will mean extra rewards. However, there is a point where putting in more work will yield little, if any, results. In some cases, putting in extra effort can actually be destructive if it pushes us to the limit where we become burnt out. Finding the right medium of paying attention to finances without going overboard with it is the key for each of us to find.

Taking the Fear out of Paying for College

We keep on hearing about astronomical increases in college costs making it a tougher burden for children to go to school to achieve their dreams. We can point to annual increases of 5% to 8% and wonder how can college cost continue to increase more than inflation year after year? However, when we talk in percentages like this, it is easy to fear how anyone can afford college these days. We start wondering if college is starting to become out of reach for some. The basis of this article is to try to put things into perspective. College is a major investment, one that should not be taken lightly. However, when put into perspective, college is still a great bargain.

The average cost of 2006-2007 tuition and fees are $22,218 for private college and $5,836 for public college (not including room or board). Most people focus on the cost of private college because $22,218 is tough for a middle class family to pay for. However, the tuition cost is very dependent on where you go. For example, approximately 65 percent of students in a 4-year college pay less than $9,000 in tuition and fees thanks to the bargain of a public college education (this is before scholarships and other aid). What people worry about is the continue increase in the cost of public education which creates a sticker shock.

In people’s mind, a bargain 20-year ago can not still be a bargain today after the double digit increases. According to College Board, the average cost of college tuition increase by approximately 113% for private college and 143% for public tuition from 1985-86 academic year to 2005-06 assuming constant dollars (in other words, after reflecting for inflation). This sounds like a lot of money which is what we concentrate on. However at the same time, the amount of grants and other aid have also increased to help offset the costs. The average grant awarded increased by approximately 126% while the amount of federal loans increased by 155%. So while the cost of an education has gone up, so has the amount of assistance, thus offsetting some of the additional costs.

Due to the cost increases, everyone discusses how much of a burden college graduates are under with loans after they graduate. However, is it really? We can look at someone who has a $100,000 loan due to going to an Ivy League college or graduate school. However, the median loan for a college graduate (according to College Board) was $19,300 for a 4-year bachelor’s degree in 2003-04. Based on a 15-year loan at 7% interest, the monthly payment upon graduation is a mere $173. Now, if we are realistic and honest, is $173 a large amount to pay? For people are living paycheck to paycheck, this may seem like a lot of money until we look at it compared to some other statistic:

• This is less than a normal car payment even for an economy car

• This is almost equal to the money that college graduates will spend going out to eat with their co-workers ($6 a day X 22 days per month = $132)

• The average college graduate earns approximately $14,000 more a year than someone who has a high school diploma out of college (according to College Board)

• In 2005, the unemployment rate of college graduates was less than ½ the rate of high school graduate (per College Board – 5.4% for high school graduates versus 2.3% for college graduates)

And, the burden does not only have to be on the children. As parents, there is room in the budget for college as well.

• The cost of a public education, $5,836 (without room and board), is only slightly more than the cost of day care paid when our children were younger (currently it averages about $100 a week X 52 weeks = $5,200).

• For stay-at-home parents, the cost of a public education is less than a parent would earn going back to the workforce after raising their children ($8 per hour X 2,000 hours = $16,000 * (1 – 30% tax rate) = $11,200)

• The cost of raising a child to age 18 (including food, clothing, housing, transportation, etc.) for a middle class family is approximately $190,000 per U.S. Agricultural Department. What is the cost of a public education to finish our children’s development compared to the investment in hours and costs that we as parents already have put in?

Now, I am not advocating that parents need to pay for their child’s education. I paid most of my way through college (by working summer jobs and graduating in 3 years) while my wife got scholarships and took out loans for graduate school. What I am trying to point out is that there are options. When we break down large costs into parts where college can be partially paid for (or financed) by parents, by children and by taking out a loan or scholarship, it become much more manageable. For parents who do not want to pay for college; an alternative is to provide a loan with the money freed up from all the costs of raising a child.

From my perspective, a teenager paying for their college expenses is a way to teach children about the value of money. I became more aware of the value of money when I had to write my tuition checks and decided that what I was paying for college was not worth going back for my senior year (thus decided to graduate early). I wrote an article earlier about teaching the children about money. In it, I pointed out that some children have a rude awakening when they do graduate from college because they lived at home when their parents had some of their highest standards of living, yet have no idea what is like living on an entry level salary especially if their college was paid for and they only had to pay minimal expenses from their part-time earnings. This is probably has led to some teens having an increased in lifestyle than teens 20 years ago.

• In a small survey of 500 high school students at 11 schools, 25% of students who were aware of the new Apple iPhone (of which 85% of 500 students knew about it) where willing to pay $500 or more for one per Piper Jaffray (along with the monthly cell phone bill).

• Per Your Prom magazine (Conde Nast Bridal Group), the average cost per prom goers is $600 each (total of $4 billion spent nationally).

• The average teen spent $104 a week ($5,328 annually) in 2001 according to Teen Research Unlimited which is about the average cost of a public education.

• Now 11% of teens 18 to 19 have a new car and 47% have a used car. This is up from 1999 when 5% of teens had a new car and 12% had a use car according to Teen Research. With the average cost of operating and financing costing $7,800 (per AAA), you start to wonder what is more important (education or car)?

If teens took a little of their spending in high school and saved it for their upcoming college years, it would make it a little easier. However, most teens would prefer spending money on a car than a college. Per a Fidelity survey, if they were given $500 and asked how they will spend it, 58% would spend some or all of it on a large purchase, like a car, while only 47% would save some or all of it for college.

Lastly, preparing in high school for scholarships is very important. The average grant per full time student was $4,433 (more for private colleges and less for public colleges on average due to the differences in costs). In addition, parents typically receive $448 in tax benefits. Note, this is a large portion of the cost of college. Yet, because many students are fighting for the same scholarships, it will take some extra effort to be in position for this money. Yet, for 4 years of $4,000+ scholarships and grants, it is time well spent.

Trying to pay for college in one fell swoop is very costly. Yet, when we take a step back and see college in context of:

• Long-term benefits with high pay and lower unemployment

• Teen spending on other things such as cars and proms

• Costs of raising children

• Scholarships available

• Ability to repay loans after graduation

Then college becomes much more manageable than by just focusing on the tuition costs increasing significantly over the last two decades and fearing how children these days can afford it.

If everyone wants to go to an Ivy League college, it will be expensive. Yet, there are many reasonably priced public and private colleges. If we select a reasonable priced school and are able to save a little before college, to work during college, to get an average scholarship and get a reasonable loan then it becomes much more managable even for a private education. Imagine a college costing $20,000 a year for 4 years (note, this is significantly more than the average student pays when factoring in public education even with room and board). If we are able to split this into 4 components:

• Savings of $20,000 ($850 a year for 18 years if done since birth and invested at 3% real rate of return (net inflation) or $5,000 a year from part-time jobs in high school for 4 years. It is even easier if parents do a little and teens do a little)

• Scholarship of $5,000 a year for 4 years

• Work during the summer in an internship position where $5,000 is not that far fetch (maybe a little less for Freshman and Sophomore years) – if needed there are part-time weekend jobs during the school year

• Take out a loan for the remaining amount (keeping the balance and payback amount reasonable compared to your projected earnings after school).

I never meant to imply that paying for college would be easy. Yet, it is easier if we take it in portions and see that it is still a good investment in a teen’s future rather than focusing on the cost increases over the years and getting discouraged.

For other articles on teens paying for college, see
Is College Education Worth It?
Young & Broke?