The past year has presented all of us with unforeseen challenges, both financial and emotional. It’s reinforced the need to have an emergency fund and may have displayed some shortcomings in our own preparedness.
This fund should be prepared for and used in the case of a being laid off, suffering a disability which keeps you from working, medical expenses, auto repairs, urgent home repairs such as a bursting pipe or malfunctioning heater, and any other true emergency. The keen reader will notice several of these risks and thus the size of the fund can be minimized through proper insurance.
How big should the fund be?
We often hear 3-6 month of expenses is the goal, but there’s a big difference between those two account balance totals. Ultimately your fund will be determined by your ability to save, your personal risk tolerance, and the risk currently held.
The Ability to Save
If saving for an emergency fund is unimaginable, expenses are too high. We are not truly within our means if we are not financially prepared for an emergency. Plain and simple, expenses should be lowered until a safety net can be developed.
Personal Risk Tolerance
An emergency fund is an essential part of any financial plan and it can’t be advised to go without one.
Risk Currently Held
This includes factors like your employment, health, insurance coverage, and discretionary expenses which would be cut in the event of an emergency.
The risk of layoffs in otherwise steady lines of work has been showcased over the past year. Both short term and long-term unemployment have dramatically increased due to factors outside of our control. You shouldn’t just prepare for a pandemic though, there are more reasonable and expected issues surrounding employment. If working in a seasonal or volatile industry such as certain types of construction or freelance consulting, your emergency fund should reflect your above average risk of being without work over short periods of time.
Set costs also factor into risk; how much are you obligated to pay each month. What is required each month to pay rent or a mortgage, make payments on debt, and purchase necessities. If your monthly expenses are high due to discretionary spending the size of an emergency fund can be realistically lowered to reflect a cut in spending on wants which would occur in a crisis.
The cost of emergencies can be reduced as well through proper insurance coverage. Disability insurance whether through an employer or purchased independently can dramatically reduce the potential risk of both short and long-term disabilities and the financial threat they pose. Auto and home insurance can also mitigate the risk your emergency fund has to account for. This does not mean simply purchasing whichever policy has the lowest deductible. That approach may result in overpaying. To speak with a financial advisor about what deductible would fit best into your financial plan schedule a complementary consultation.
Where should an emergency fund be kept?
Many feel a disdain for an emergency fund because in their mind, the money is sitting unused. They would prefer to have the ability to either spend it or put it to work in an investment. This is normal, but it’s important to remember investments carry risks and/or lack liquidity and the emergency fund is what allows them to have investments and still ensure security. An emergency fund should not be kept in a shoebox (this presents a security threat in itself) or in an illiquid account.
Keeping the money “in your house” in the form of home equity can also carry an inherent risk. Think back to the crash of 2008 when the lives of many families were uprooted. If when you need it most the bank can tell you, “no, we won’t give you a home mortgage loan, because it does not make good business sense” then home equity is not a good place to keep an emergency fund. If an emergency is created by damage to your home caused by a fire or tornado or any other cause, this will of course have an incredibly negative effect on your home equity strategy.
Better options include a traditional savings account or a money market savings account which generally earns more interest. While these generate little if any interest it’s preferable to keeping money buried in the yard. For an option which can generate higher interest and will even generate interest while your money is in use click here to speak with Michael Romanello about your options.
Commonly Forgotten, but incredibly important -
1. Taxes must be input when calculating your expenses. Sales tax, for example, can range anywhere from 0% to 14% depending on the county and state purchases are made in. If your emergency fund fails to account for, say a 7% sales tax in your locality, that’s 7% less buying power for you and any dependents; something that can’t be afforded in a crisis.
2. An emergency fund should be kept independent from other savings. If you prefer to make down payments on auto loans, they should not be deducted from your emergency fund since they do not qualify as emergencies.
3. In another potential pandemic the government can’t be relied on to fund your budget. The United States government have set shocking precedents in the past year by granting massive amounts of money in stimulus. Although, the speed at which those payments were arranged and delivered alone should be enough to convince you of the need to become financially independent.
Developing a plan and putting it into action –
To speak with a financial advisor about what you can do to prepare for and reduce the impact of unexpected emergencies, set up a complementary consultation. View our availabilities and set up a phone call, Zoom meeting, or in person meeting at our Westlake, Ohio office today.