Why you need an emergency fund

Post date: Dec 03, 2015 12:53:20 PM

Being prepared for anything is an essential part of financial security.

On the excitement meter, a “rainy day” fund might barely move the needle, particularly when compared with other financial goals such as saving for college, a retirement account, or a down payment on a new home. Yet investors who fail to include an emergency fund in their planning do so at their peril.

Being unprepared for an emergency—anything from a flood to losing your job—can force you into a financial hole. The unexpected can happen to anyone, regardless of age or income level, and it can take years to recover if you are not financially prepared.

A recent study published by the National Bureau of Economic Research and the Brookings Institution found that 50% of Americans—and nearly 15% of households earning $150,000 or more a year—couldn’t come up with $2,000 in cash to cover an unexpected auto emergency, medical bill, or home repair.1

This is why creating an emergency fund should be considered a priority. Maybe you’re just starting a career and are inclined to take your chances. Or maybe you think your net worth has grown enough to make an emergency fund unnecessary. The problem is, you may be wrong. Having a cash reserve can help protect you against unexpected financial difficulties that can have lasting consequences, even if you feel you are in good shape today.

How much do you need?

A.D. Financial Planning recommends the following emergency fund:

This guidance may not fit everyone. You will need to take into account your expenses, liabilities, and other individual circumstances in order to get a dollar figure that suits your needs.If you’re single and on your own but have family backup, you might be comfortable with three months of savings. However, if you have a spouse, kids, and a mortgage to support, you might sleep better with six months or even 12 months of funding in reserve.

Remember to consider the full list of potential emergencies you could encounter, which might range from a disability or illness to a major housing repair or loss of employment. Make sure you check your disability insurance—either at work or as an individual—so that you know both how long your policy requires you to be disabled before benefits begin and how long they’ll last.

And when you are calculating your living expenses, keep in mind that if you lose your job, you’ll also lose your health insurance coverage. This means you’ll need additional emergency fund money to cover the cost of your health care coverage through COBRA.

Coming up with the cash

Once you’ve decided how much in emergency savings you’ll need, you’ll have to find the dollars to fund your cash reserve. A windfall such as an inheritance or a gift from a parent or grandparent is a great source of cash for starting a rainy day fund. Most people, however, will likely find that the process of building an emergency fund takes place while juggling other saving and spending priorities.

The 10 Steps to Financial Freedom recommended by A.D. Financial Planning gives you clear steps on your financial road for when to start and when to expand emergency fund. In order to build your emergency fund it must be part of your monthly budget. When you reach the target number for your emergency fund, you can start working toward saving for a down payment on a home, increasing your retirement savings in your 401(k) or 403(b) plan, IRA, or other tax-advantaged plan then saving for your child's education.

Possible pitfalls

Some people view their 401(k) plan as a source of emergency cash, because you can borrow money from a 401(k) if your plan allows. This approach, however, comes with some real perils. If you leave your employer for any reason, you will likely have to pay the loan back within a maximum of 90 days. Moreover, if you fail to pay the loan back in that time, you’ll be subject to both income tax and a 10% early withdrawal penalty.

Others view their credit card as an emergency plan. Credit card balances that are not paid of monthly are fraught with fees, penalties and high interest rates. Using a credit card to bail yourself out of a financial hole is the equivalent of using a shovel to dig yourself out of a hole - you are only going to get deeper! 

Keep your rainy day fund up to date

Once you have established your rainy day fund, resist the temptation to dip into it for non-emergencies. If you start to treat it as a backup when you’re running short, it’ll disappear before you know it. As your expenses grow, so should your cash reserve.

Likewise, if your expenses decrease—as children leave the nest, for example—you might be able to trim your emergency fund. To keep it current with your changing circumstances, consider making it part of your list of items to revisit during your annual financial checkup.

Whatever your age or income level, an emergency fund is an important part of a well-rounded plan for your financial security. Life is full of competing demands for your money, and a cash reserve can play a crucial role in keeping you on track with your other financial objectives.

To discuss emergency funds or just where to begin on your path to financial freedom, contact A.D. Financial Planning.

1. Annamaria Lusardi, Daniel Schneider, and Peter Tufano, “Financially Fragile Households: Evidence and Implications,” National Bureau of Economic Research and the Brookings Institution, 2011.