It appears emergency funds are like so many things in our life. Their importance does not seem very high, that is until they are needed or missed. And if they are non-existent when needed, there is not much that can be done to create them on the fly.
For those of you who have been adversely impacted already by the downturn in our economy, I wish you well and hope you were prepared as best as possible. For the rest of us, it is not too late to take steps to become prepared.
Here are a few steps you can take that will not only improve your financial readiness in the event of an emergency, but perhaps your peace of mind as well.
Determine how much short-term emergency funds are needed. This is the amount of money needed each year to cover the everyday emergency, such as an auto accident or trip to the emergency room. This should be kept in a savings account with easy access.
Determine the amount of access to cash from savings or investments that could be used to replace income in the event of a job loss. Retirement assets should not be included in this figure. Three months of income is the smallest amount, with nine months to a year as the most conservative amounts.
Remove all credit cards from your wallet or purse with the exception of one. If you use a debit card instead of checks, still keep one credit card for emergencies that might exceed the availability of cash in your checking.
If there are not sufficient funds in the two emergency accounts, then a reduction in spending is required so the value in these accounts can be built to the desired levels. A reduction in discretionary spending can create additional cash for these accounts. Also, paying only the minimums on existing debt may create available cash.
For some, taking a part-time job may create the additional cash for emergency funds as well as a way to reduce debt once the emergency funds are at the desired levels.
Evaluate all spending and make sure full benefit is being received. Here are a few examples: is the health club membership being used effectively; can a less expensive auto be used; can the insurance deductibles be increased to create savings; are the interest rates as low as possible?
Americans can be the king and queen of “stuff.” Are there extra items that can be sold in a garage sale or on the Internet? Take a look in the attic and closets. There may be enough to pay off one credit card or make one car payment.
Taking some or all of these steps may enable you to handle a financial emergency a lot easier. Even without an emergency, avoiding wasting cash is always a good thing. The recommendation to pay only the minimum required payments on credit cards does require additional commentary. Paying off (down) credit cards is always a good step to take. However, if you do not have any emergency funds, then every financial crisis will require the use of credit. And in many cases, one new charge can wipe out several months of reductions. Thus, if the excess payments over the minimums are used to create an emergency fund, then new credit charges will not be required. As soon as the emergency funds have the balances you may need, then return to paying not only the minimum payment but a fixed extra amount as well.
I have written on this topic in the past, but a brief refresher could not hurt. The extra payment on the credit cards should be concentrated on a single account. In my opinion, you should first concentrate on the smallest accounts. Thus, you will have success early by paying off some of the smaller account balances. You will also do away with one minimum payment amount. As each account is paid, the entire amount applied to the account just paid-off should then be applied to the next largest account. Once all of the remaining accounts are similar in size, concentrate on the accounts with the highest interest rates.
I also mentioned retirement accounts should not be used as emergency funds. Doing so is extremely costly. Taking money out of an IRA account subjects you to a 10% penalty due on the next tax return as well as income tax on the entire amount withdrawn. This may be another 10 to 30% depending upon your tax bracket. To lose as much as 30 to 40 cents of each dollar withdrawn is too costly in my opinion. While there are occasions where it cannot be helped, it is best to avoid if possible.
The rough economy is not over, but we may be closer to the end than the start. If you have questions, please contact my office or any of the CFP’s in the area.