How to Avoid the Next Financial Emergency

How to Avoid the Next Financial Emergency

At a speech in Washington a few weeks ago Federal Reserve Chair Janet Yellen declared that a large number of American families are “extraordinarily vulnerable” to financial setbacks because they have few assets to fall back on.  To them, a financial crisis is a month or two without a paycheck.  By contrast, she went on to say, families with assets are in a much better position to treat financial setbacks as just “bumps in the road.”  But even for well-off families or individuals, a bump can easily turn into a crater if they are not financially prepared.  The simple solution is to maintain what is called an emergency fund.  But how much is needed, and where should it be kept?  The answer, as always when it comes to financial planning, is “it depends.”

In order to come up with an appropriately-sized emergency fund, the first step is to determine your family’s needs.  The most important expenses to include are your fixed or non-discretionary expenses – those that cover the basics such as food, shelter, and transportation, without which you could not survive.  If you want to be even more conservative you can include all your expenses (e.g. restaurants, vacations, entertainment, etc.), not just the non-discretionary kind.  But be sure to include only those that are recurring.  A roof repair, for example, is not something your emergency fund would be designed to address.  (Insurance should be used to address unplanned expenses).

Although most expenses are paid monthly, some (such as property taxes) are paid infrequently during the year.  For that reason I recommend collecting your expense data over a one year period and then dividing that number by twelve to get your average monthly expenses.

Now that you’ve figured out your expenses, how much money should you be putting aside into an emergency fund?  There are a couple of rules of thumb.  If you’re a single wage earner, at least 6 months’ worth of expenses is generally recommended.  If you have substantial savings or investments or permanent life insurance (from which you can borrow), 3 months’ worth might be sufficient.  Partly the answer depends on your own personal risk tolerance as well as your level of confidence in your ability to quickly get another job should you lose your current one.  If you’re very conservative, make it larger.  I’ve had clients with emergency funds supporting over one year’s worth of expenses.

What if you’re married?  If only one spouse is working, or you are both working but have children, 6 months’ worth would be the recommended size of an emergency fund.  But again, if you have enough liquid assets from which you could draw, 3 months’ worth might be OK.

The next consideration is where to hold your emergency fund.  It should be held in an account from which you can quickly (but not too quickly) access it and turn it into cash without penalty.  That excludes most retirement accounts such as IRAs.  It also excludes your checking account (which should be used primarily for day-to-day cash flow liquidity) as well as most bank CDs (which penalize you for early withdrawals).  You might consider putting it into a brokerage account somewhere where you are not likely to tap into it indiscriminately but can still access it quickly if needed.

What about investing it?  You should be extremely conservative with this money.  Definitely do not put it into stocks or real estate.  Money market funds are very good choices except that they are not generating any returns these days.  But have patience – this will change.  Very short-term bond funds would be a good alternative in the current low-interest environment.

Some consider credit cards as a reasonable alternative to cover emergency cash needs.  I would recommend treating them as a supplement to an emergency fund, not as a replacement.  Many people were forced to build up large balances on their cards after the 2008 meltdown.  With card interest rates remaining in the high double digits, paying down a large credit card balance could turn out to be a huge financial burden that could take many years to resolve.

If you make the effort to determine how much of an emergency fund you need, accumulate it, and invest it safely and wisely, I’m sure Janet Yellin would approve!

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