An Emergency Fund: Your First Line Of Defense
by David Berky
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Downsizing, rightsizing, forced retirement, layoffs,
firings, outsourcing, and being made redundant.
All
could mean the same thing to you: financial catastrophe.
No,
you may not have to declare bankruptcy or move back in with your
parents, but losing your job could put a big dent in your financial
goals and even set you back several years. You may need to live on your
savings or liquidate some of your investments.
If
you have no savings or investments you may have to rely on credit cards
and could rack up significant credit card debt. Then when you find a new
job, your expenses may have increased because of the additional credit
card payments.
And
the job you eventually find may not pay as much as the one you lost. So
you are now forced to live on less while your expenses have either
continued at the same level or even gone up.
Studies
show that the average worker will have six career changes in his or her
lifetime. Not just job changes, but career changes.
So
how can you prepare for your own financial "downtime"?
An
emergency fund.
An
emergency fund is really just savings. But it is not savings for a
particular item or even an investment for your future or your
retirement. It is your "rainy-day" fund. But unlike insurance
where once you pay your premium, the money is out of your hands, your
emergency fund is yours to keep.
So
how much do you need? How can you build your emergency fund? And where
should you keep the money?
The
easiest way to figure out how large your emergency fund should be is to
take your current income and multiply it by the number of months you
could be out of work. If you make $3,000 each month and you want to be
prepared for a 6 month "vacation", you will need $18,000.
But
obviously saving $18,000 will take some time. How quickly you want to
build your emergency fund depends on how concerned you may be about your
current and future employment prospects.
Saving
$100 each month will take you 180 months or 15 years. Saving more each
month means you will be protected sooner. Also consider that during the
next 15 years your income may increase and your expenses usually rise to
match your income.
Also
consider inflation. (If you own your home, your house payment may not
rise. If you are renting, your rent probably will.) The cost of food,
utilities and taxes also rise over the years. At a 3% inflation rate
after 15 years your $18,000 will only buy $11,400 worth of goods.
A
good rule of thumb for saving is to try to save enough each year to
supply you with one month's income. This means you are saving 1/12 or
8.3% of your monthly income.
This
will allow you to build your emergency fund by one month every year.
After only six years you will have a six-month supply of emergency cash.
Then you can continue to extend your "coverage-period" or you
can divert the monthly payment into other savings or investments.
Most
people find that "billing" themselves for savings and
investments is a good way to put your savings on auto-pilot. If an
amount is taken automatically from your bank account each month, it is
easier to handle than if you wait until the end of the month and try to
save from what you have left over. (How often do you have anything left
over?)
So
where is the best place to keep your emergency fund? Probably not a
place where you can have easy access to it - too tempting. Definitely
not as cash in the cookie jar - too unsafe (and no interest). And
probably not in 5 year CDs - too restrictive. You may want to avoid CDs
altogether so that you are not charged an early withdrawal penalty when
you can least afford it.
Savings
accounts are OK, but usually pay very little interest. If a savings
account is your choice, open one at a bank that you don't regularly use.
Also don't get a checking account to avoid the temptation to spend
"just a little" bit here and there.
Or
look for a money market account that pays a reasonable interest rate.
You may want to consider a money market account that only invests in
tax-free securities. This way you won't have to worry about paying taxes
on your interest.
Then
set up an auto-withdrawal from your regular checking account or direct
deposit amount from your pay check right into this new account. Adjust
your budget to accommodate having less money each month and forget about
it.
You
can also give your emergency fund a boost now and then by putting
"windfall" money into to it. You know "free-money";
birthday gifts, inheritances, insurance settlements, escrow overages,
rebates, tax refunds, etc.
Your
emergency fund becomes your own financial insurance policy. And if you
never use it you will have that much more money to play with when you
retire. Or even retire early with the extra money you have saved.
Keywords:
emergency fund protection financial insurance david berky simple joe
About
the Author
David Berky,
dave@simplejoe.com
http://www.simplejoe.com
David Berky is president of Simple Joe, Inc., a marketing company that
sells simple software under the brand name "Simple Joe". One
of simple Joe's best selling products is Simple
Joe's Money Tools - a collection of 14 personal finance and investment
calculators.
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