Emergency Plan: Better Than an Emergency Fund
Last year with the world economy in turmoil, Suze Orman, arguably one of the most vocal personal finance gurus, revised her emergency fund philosophy. Suze began advising her readers and listeners to put aside accelerated debt repayment in favor of building "as much of an emergency fund as you can...even if it means curtailing your credit card repayment strategy."
With job losses in the news, the prevailing rule of thumb came to rest on a larger-than-life bank account set aside only for emergencies. Some personal finance experts began calling for Emergency Funds holding six to twelve months' worth of household expenses while others wanted to link the size of the bank account to the unemployment rate. For every percentage point of unemployment, safe savers would have one months' worth of expenses set aside in a high-yield savings account.
According to the Bureau of Labor Statistics, the average family spent over $4,000 a month in 2008. Even if we assume only $2,500 of that represented necessary expenses, a 10% unemployment rate would result in an emergency fund totaling $25,000. That's too much cash to have sitting around earning ridiculously low interest. You lose purchasing power because your after-tax returns on cash, even in high-yield savings accounts, are not going to beat inflation.
I suggest a tiered approach to let your Emergency Fund work a little harder for you while still ensuring you're covered in an emergency. This is broader than just an Emergency Fund; it's an Emergency Plan.
1. Store cash somewhere safe in your house
Before I'm accused of being paranoid, having perhaps one hundred dollars hidden in a place a burglar wouldn't look will help you get to a cash machine or a bank in an emergency situation. As I mentioned, you want your money to work for you, so you don't want to leave more than a small amount in First Bank of Mattress.
2. Open a high-yield savings account
These days, the term "high-yield" is more of a joke than anything else. Yes, by opening an account in one of these online savings accounts, you will be earning more than you would in traditional savings accounts offered in bank branches, but it's not much. To choose the right bank, weigh the interest rate against how fast you can get the money in your hands. Consider keeping three to six months' worth of expenses between cash in your house and in the bank.
3. Invest the rest
Temporary emergencies like the loss of a job are, in normal times, resolved within six months. Chances are good you won't need to touch your investment. But if you deplete your savings and need to come up with more cash, start with your Roth IRA. Your contributions can be withdrawn at any time tax-free and penalty-free, and if your situation is resolved, you can re-contribute your withdrawn funds. Without a Roth IRA, you would have to sell taxable investments. This is not a preferred option, but that is why I suggest having a six-month buffer in cash.
Editor's Note: A commenter below mentioned that there are certain requirements you have to meet in order to withdraw assets penalty-free.
4. Access your credit
Always keep an unused credit card at the ready. I am not opposed to recommending the use of credit cards in emergency situations to people who have shown responsibility with their finances. Going into debt is not ideal, so avoid it if possible. The best scenario would be to use a credit card only when you know your emergency situation will be resolved before your bill is due.
Don't take a loan from your 401(k). Doing so would expose you to significant risk. For example, if the economy is not doing well and you find yourself struggling, chances are your employer is struggling as well. You don't want to take a loan from your 401(k) and find yourself out of a job — your loan will become due immediately.
If you own a home, you have access to what might be "slightly better" than credit cards, a home equity line of credit. Rates are often lower but there is a danger of losing sight of your debt. Debt in any form should not be your only emergency plan.
5. Ask for help from family and friends
No one likes to admit they need help. If you're generally well-prepared, emergencies shouldn't come along too often. As long as you are in a true emergency, are seen as trustworthy, and don't have a history of asking for financial favors, your family and friends might help if they are in a position to do so. I've found the more compassionate you are, the more likely the people in your life will be compassionate towards you. But just like credit, asking for favors should be a last resort.
6. Reduce your expenses
I'm including this at the bottom of the list because it isn't technically a way to access money, but this should probably be the first thing you think of in a emergency situation — once you are clear of any immediate danger. Reducing your expenses will make tiers one through five last longer or go farther. Consider making sacrifices you wouldn't ordinarily make and taking a few more steps towards frugality.
What is your Emergency Plan? What do you do beyond keeping cash in a savings account to prepare for when you won't be able to use your income to pay your expenses?
This is a guest article by Flexo of Consumerism Commentary, a founding member of the Money Tips Network. Flexo is starting the second week of his ten-day, ten-venue tour. If you enjoyed this article, please subscribe to his RSS feed, follow him on Twitter, or check out some of his best articles: