Lesson
4c: Emergency Fund
Objective: Determine
how much of an emergency fund you want.
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No one thinks of an emergency fund as an insurance fund,
yet it is.
An emergency fund has two purposes:
- To provide a safety net against unexpected expenses (e.g., your furnace
needing to be replaced just as your car broke down as well)
- To cover living expenses if a wage earner loses his/her job
or becomes disabled
Having an emergency fund will make it less likely for you to
rely on short-term loans with high costs (e.g., credit card
debit and
payday loans), and will allow you to avoid selling
investments prematurely if the markets
are
down
(e.g., if you lose your job during a recession).
An emergency fund is not for:
- Holiday presents
- Routine repairs (e.g., car breaking down or appliance needing repair)
- Replacing household furniture
- Vacations
These expenses should be planned for and covered under
your budget. If you do not plan for these items,
they become emergencies and unfortunately, become a big source of
credit card debt. Items
like
holiday
expenses
should
be held in a separate account. For
example, instead of using the emergency fund to pay for a $500
holiday present bill in December and January,
save $42
per month during
the year. This way you have $500 for your holiday presents in
your checking account when you need it.
Reason: If you use your emergency fund for routine
expenses (like holiday presents), then you will not have an adequate
emergency
fund in February if the furnace and car breaks down at the same time. The
key is to have an emergency fund for emergencies and a separate fund
for
budgeted items like vacations and presents.
How much do I need in an emergency fund?
You will get different answers from different advisors. It
all depends on your situation.
- A common first step is to build
up a $1,000 fund that will help cover many unexpected items like
your furnace breaking down.
- The next step is to build up your emergency fund to cover 3 to 9
months of living expenses. Living
expenses are items in the budget that are fixed or essential (e.g.,
mortgage, utilities, food, etc.). Living expenses do not include
vacations.
So should you plan for 3 months or 9 months of living expenses? The
more risk you have, the larger the
emergency
fund should be. Risk
can be measured by looking at the following factors:
Lower Risk
|
Higher Risk
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Reason
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| Paid by salary |
Paid by commission |
In general, being paid by salary provides a steadier flow
of cash than being paid by commission. |
| Working for a steady industry (e.g., health care) |
Working for a volatile industry (e.g., retail) |
Volatile industries are more dependent on the economy and
will have more layoffs in down economies. |
| Working in a field with low unemployment (e.g., nursing) |
Working in a field with high unemployment (e.g., manufacturing) |
If you lose your job but have skills in high demand, you
will have an easier time finding a new job. |
| Having disability insurance (short-term and long-term) |
Not having disability insurance |
If you have insurance, you have reduced your risk. |
| Having an advanced degree |
Not having a high school degree |
Those with advanced degrees are in more demand and are more
qualified for other careers as well. |
| Dual wage earners |
Single wage earner |
With two wage earners, there is a second income if one person
loses his job or becomes disabled. |
| Having liquid assets to use if needed |
Having little or no liquid assets. A 401(k) is not
a liquid asset! |
If you have a vacation or educational fund, you can always
tap into this if needed for an emergency. |
| Being healthy |
Having chronic illnesses |
Having chronic illnesses increases your need for disability
insurance and/or an emergency fund. |
| Living expenses that depend on 60% to 70% of income |
Living expenses that depend on 100% of income |
If you lose your job or become disabled, disability and unemployment
benefits usually only pay 50% to 80% of your previous pay. So
if you have more expenses, you need a larger emergency fund. |
| Stable family |
Possible changes (baby or divorce) |
Usually the additional expenses or lose of income for these
events are not planned for, even though
for many, they have a good idea of the likelihood that
these events may occur in their particular situation. |
The key to an emergency fund is to have cash to fund your expenses
in case you lose your job or become disabled. With
an emergency fund, you are less likely to rely on high-cost alternatives
such as using credit cards or payday loans, for example. However,
many do not plan for these events to happen (possibly thinking
they are not even an once-in-a-lifetime event) and are then caught
short when they do occur. Remember, being disabled for 90+
days occurs to at least one in every five workers at some point
in their career and the chance of being unemployed is much greater
than being disabled.
How do I invest an emergency fund?
52%
of employees live paycheck to paycheck including 34% of those
with earnings of $75,000 or more.
-2003 MetLife Study of Employee Benefits Trends
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Emergency funds should be placed into separate accounts like money
market accounts (to earn some interest while protecting the principal)
and not
in your
day-to-day
checking
account which you may be tempted to use for
day-to-day expenses. Emergency
funds should not be invested in stocks or bonds because if there is an
economic
downturn, the fund may have declined in value just as you need
the money
Exercise: Determine the following:
- How large of an emergency fund do you want?
- How much do you already have allocated to an emergency fund?
- By when do you want to save the difference in (1) and (2)? How
much do you need to save per month to accomplish your goal?
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