Having a “rainy day fund” in place to help you pay for emergency expenses has long been one of the foundations of a solid financial plan. But the importance of having a cash reserve that is liquid and easily accessible has become more apparent given the hard financial realities faced by many families due to challenging economic conditions. Even if the importance of such a fund is obvious, managing to build sufficient savings can prove difficult. Consider the following guidance as you begin to accumulate, maintain or grow your emergency fund.
How much is enough?
A general rule of thumb is that you should have the equivalent of three to six months worth of living expenses safely tucked away in a liquid savings account. So if your family’s expenses run approximately $4,000 per month, your cash reserve should be somewhere in the range of $12,000 to $24,000.
Yet some have found out the hard way that even this amount of money can be inadequate. Emergency funds are usually considered a way to cover bills in case of a temporary job loss or if a major household expense occurred, such as an unexpected car or home repair. But the reality is that many people have found themselves unemployed for longer than they imagined. Without an ample cash reserve, they risk falling behind on their mortgage, credit card debts, car payments and college loans.
A better target may be to have at least six to nine months worth of income set aside in an emergency fund in case of an event like a job loss in a tough unemployment market or significant health issue that lasts longer than you anticipated.
Making sure the money is really there
Some financial professionals recommended a home equity line of credit could effectively replace actual dollars as a cash reserve during the real estate boom of the early 2000s. Their belief was that establishing a line of credit was considered, in essence, an equivalent fallback if an emergency occurred.
This basic concept is sound, but there are some notable risks. One is that the value of your home could go down, which would likely affect the amount of home equity credit available to you. Another is that you may need to sell your home due to an inability to maintain the mortgage or if you need to relocate for work. If money is already borrowed against your home’s equity, it will have to be repaid once the house is sold; meaning the cash cushion you counted on is gone or depleted. A better option for most is to make sure that actual cash is on hand, and consider home equity a “plan B” if your rainy day fund becomes exhausted.
If your fallback plan is to use credit cards as a source of emergency cash – even temporarily – you may want to reconsider. This can further complicate your financial challenges and should not be looked upon as protection except if all other options are exhausted. The interest rates charged by most card issuers are steep, and may put you in a deeper financial hole, especially if you don’t have adequate cash flow to make regular and timely payments.
Finding money for your reserve fund
If you don’t yet have a reserve fund already or the dollars saved are inadequate, the big issue is where to start. Most likely, you won’t have a fully funded cash reserve in place overnight. Try to set aside $100 or $200 each month from your paycheck into a savings account or money market fund. This may require you to alter your spending habits, but you likely won’t regret it. If you receive a tax refund or come upon unexpected money in from another source (such as a bonus at work) consider putting some or all of that money into savings.
Over time, you will have an important financial cushion in place that should help protect you during uncertain times. But regardless of how much you are able to save, be cautious about how you manage the money. The most important role of your cash reserve is not to generate a high return, but serve as your financial backup when you really need it. Consider working with a financial advisor who can help you establish your back-up fund and while also taking in account your other financial goals.
Jeff Mushen lives in the greater Seattle area and works with his clients in downtown Edmonds. He is a CERTIFIED FINANCIAL PLANNER™ practitioner and is licensed/registered to do business with U.S. residents in the states of Alaska, Illinois, Tennessee, and Washington.
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