No one likes to think about it, but emergencies are a part of life. But just because we don’t know exactly what will happen and when, that doesn’t mean we can’t help ourselves be more prepared for them financially. That’s why establishing an emergency fund with three months of expenses is considered a foundational component for any sound financial plan. Having the dedicated fund set aside in a safe, highly liquid account can help you weather the storms that life may occasionally bring your way.
If you don’t have adequate monies in reserve, you may be forced to resort to some of the following ways of managing a crisis, which you will see are less than optimal:
Credit Cards. Using credit cards to fund a crisis is a particularly bad idea, especially if you pay high interest rates on your balances. Also, when your life is in upheaval, it can be easier to miss payment deadlines. Should this occur, you may face steep late payment fees in addition to high interest rate charges. And making late payments or utilizing more of your available credit can also hurt your FICO (Fair Isaac Corporation) score that indicates your creditworthiness, potentially making it even more difficult to borrow in the future.
Payday Loans. These are typically among the most expensive types of loans consumers can take out. They’re intended for short-term needs (payday to payday) and are not intended for sustained borrowing. People who use them routinely can fall into the trap of deeper debt fueled by ever-accumulating interest charges. And the cycle can become very difficult to break over time. Avoid this type of predatory lending whenever possible.
Raiding Your 401k. While you can borrow from your 401k and repay yourself with interest, you will face stiff penalties if you’re younger than 59½ years old and for whatever reason are unable to repay the loan, in which case you can suffer a hefty 10% penalty. There can also be an opportunity cost in terms of the time that you’re divested. You can miss out on opportunities for your retirement funds to grow that can take months or even years to recoup.
Borrowing from Family. Asking your relatives for money is never easy. It can strain relationships, especially should you have difficulty repaying the loan on time. And that can be the last thing you need when you’re facing a crisis and in need of emotional support from your family. It could also put you in an uncomfortable position should your relative face a financial crisis of his or her own and expect you to return the favor. If you do go down this route, it’s a good idea to specifically spell out the terms and conditions of the loan and its repayment in writing so there are no misunderstandings.
Home Equity Line of Credit (HELOC). If you have a HELOC, you may be tempted to utilize this to deal with a financial emergency. And while this is an option that’s open to you, there are some things you should keep in mind before doing so. First, the interest rate on these instruments is usually variable, which can make your loan payments unpredictable and more difficult to budget for. Additionally, since a HELOC is backed by the equity in your home, it’s possible to become “underwater” on your home, a state where you owe more on the house than what’s it’s worth. Finally, if you were considering taking out a HELOC, be sure to ask about all of the associated fees and closing costs that you may also face.
When it comes to a financial crisis, the best defense is a dedicated emergency fund. If you don’t currently have one, add regular contributions to your monthly budget. Once you have that money in the bank, it can greatly reduce stress about the “what ifs” we all tend to worry about.
NFPR-2019-152
One of the first lessons of finance we are taught, by our parents or through some basic personal finance course, is to make creating an emergency fund our top priority. Having a reserve of cash equivalent to six to 12 months’ worth of living expenses is considered the most fundamental principal of financial security. Yet, the reality is that less than 10 percent of income earners have enough reserve cash to cover more than a month’s worth of expenses1. Is it denial, ignorance, laziness, that leads people to the verge of bankruptcy? Or is it that they lack the ability or wherewithal to do it?
Actually, anyone, regardless of their wherewithal can create an emergency fund; however, it does require a plan and the discipline to execute it. For those on tighter budgets, it will also require some attitude adjustment regarding your spending habits. The first step in creating your emergency fund is to acknowledge the financial trouble you could find yourself in should you lose six or 12 months of income; then set a goal to prevent it. From there, just follow these essential steps:
Quantify your goal: You need to determine how many months of living expenses you need to have in reserve. The minimum should be six months; 12 months is recommended. The higher your living expenses, the longer your reserve should be.
Establish a serious budget: Now is the time to streamline your budget in anticipation of the unexpected. Your objective is to free up cash flow that can be allocated to your cash reserve. Once you determine a dollar amount or a percentage of your income you want to allocate, put yourself first in line – in other words, pay yourself first each month. If an unexpected expense creates a cash shortfall, find something else in your budget to cut, but don’t cut your savings allocations.
Establish frequent benchmarks: It’s easier to stay on track and stay motivated when you break the overall goal into monthly or quarterly benchmarks.
Make it automatic: Many banks offer savings accounts that can be set up with automatic deposits from your checking account. You won’t even feel it.
Get rid of debt: While your savings goal is the top priority, you need to create more room in your budget to reduce or eliminate debt. As you reduce your debt, the increased cash flow available can be applied to savings, thereby accelerating your savings goal.
Change your attitude about spending: While you shouldn’t have to deprive yourself of the necessities of life, a new attitude about spending could do wonders for your cash flow. Don’t buy on credit. Ask yourself if you really need it. Never pay retail. Make the things you have last longer. Do without some things for a while. Frugal is cool again. But then, when you hit or exceed your savings benchmarks, feel free to reward yourself with a small splurge.
Cover everything: Insure everything you own – your home (or, if you rent, your property), your car, your valuables, and your most important asset, your income with a disability insurance policy. For a couple of hundred dollars a year you should consider adding a personal liability umbrella policy to cover everything else.
Don’t touch it: The biggest challenge for many people is to refrain from tapping their emergency fund for reasons other than an emergency. This tends to occur early on when your new attitude and habits have yet to be fully formed. Fight the temptation.
It’s recommended that you utilize bank savings or money market account for your cash reserves. You won’t be earning a lot of interest, but your real objective is to keep your reserves safe and liquid. Once you’ve met your emergency fund savings goal, you can then allocate your monthly savings to other types of investments that can have better earning potential while enjoying greater financial confidence.
Insurance policies contain exclusions, limitations, reductions of benefits, and terms for keeping them in force. Your financial professional can provide you with costs and complete details.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing
Tags: Emergency Fund, Financial Wellness
When it comes to preparing for a rainy day, the best time to act is now. Establishing a 3-month or $10,000 emergency fund is a critical pillar to your financial wellness - and it will help you sleep a whole lot better at night.
But how can you find room for this essential line item in an already tight budget? Here are 12 tips to help get you there.
We encourage you to set up an appointment to discuss your emergency fund and all your retirement needs with your 401k advisor today - your financial future just may depend on it.
Tags: budget, emergency fund, save
1. https://www.bankrate.com/banking/savings/financial-security-0118/
2. https://www.irs.gov/retirement-plans/401k-plan-catch-up-contribution-eligibility
NFPR-2019-71 ACR#324824 08/19
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