When creating your financial plan, establishing an emergency fund or a financial reserve is critical to your financial health and peace of mind.
Before we go any further, think about this.... How would you pay your bills if your paychecks suddenly stopped?
What happens when you need an expensive prescription only to discover that it isn’t covered in your medical insurance?
Should you become disabled or lose your job, how will your dependants survive till the paychecks start up again?
How many times has your paycheck delayed and you ran around crazy looking for someone to bail you out because your landlord was threatening to throw you out of ‘your house’?
What will you do if your house is destroyed by fire and you have neither household or renter’s insurance nor a reserve fund to provide an emergency shelter for your family?... “Well wishers will chip in”, Is that what you are thinking? I hope you can bet they won’t be broke like you at that time.
It’s terrible to be in such circumstances!
If there’s one thing you can be certain of in life, it’s the uncertainties. No matter how carefully you plan out your expenses, there will always be those that you didn’t account for.
Just take a moment and think, how would you feel if you were prepared for such eventualities? I bet the peace of mind you’ll enjoy is incomparable to what you would have felt had you not stashed away some cash in advance.
It’s not enough to make sure you’ve paid down your debts or you are investing for your eventual retirement. An emergency fund must be a part of any sound financial plan. Ideally your emergency fund should allow you to maintain the same quality of life you have now.
Financial planners recommend that you should have three (3) to six months (6) of expenses set aside. But considering the harsh economic times we are in now and with an unemployment rate that is at its highest, that’s not necessarily enough. You may need to revise that time frame to between six (6) to twelve (12) months.
Emergency funds are supposed to be in liquid investments where it would be easy to access the funds when you have an emergency. Liquidity refers to how quickly an asset can be converted into cash.
A house is not a liquid asset because it could take months to sell it. Stocks are somewhat more liquid than real estate, but one can lose money on stocks if forced to sell at a time when the market for the stock is less than favorable.
So where should you put the money? Under your mattress? Nope! I don’t think so. Put that money into a high interest earning account like high yield savings account. A savings account provides the best balance between liquidity and the ability to earn interest on your money. Even though interest on liquid investments may barely keep up with inflation, the lower risk is worth the lower return when one may require the money quickly.
You may also consider using money market funds. They are good, stable investment vehicles that are somewhat immune to the ups and downs of the financial markets. They invest in Treasury bills, bonds and other low-risk instruments that typically pay higher returns than savings accounts.
Once you have built an emergency fund, it is very important that you use it for true emergencies only. Emergencies are things that are crucial for your survival. Here are some examples:
Don’t use it for:
Before you dip into your reserve fund, always think of less expensive alternatives that can be used until you can afford to cover the “emergency” out of your regular income or other financial resources.
Always replace any money you spend from your emergency fund. Otherwise, your fund will get depleted and won’t be there when you need it.
Next Article: Emergency Fund vs. Emergency Plan