Building an emergency fund
money into an emergency fund is like going to the dentist. You know you should
do it but, um ... maybe next month.
When Bankrate.com's financial literacy study asked 1,000 people
how important is it to keep at least three months' living expenses in an emergency
fund, 66 percent said it was very important, and another 26 percent said it
was somewhat important.
But only 40 percent of those surveyed said they keep the money
on hand all the time, while 28 percent said they sometimes have the cash.
That's a pretty significant disconnect between what people know
they should be doing and what they actually do. In fact, of all the questions
asked in the survey, it showed the widest discrepancy.
What does it take to make us get serious about doing something
that can keep us solvent during rough times?
Even with the once mighty U.S. economy looking like a punch-drunk
boxer down on the mat, struggling to focus and get back on his feet; too many
of us are out of shape financially despite witnessing years of layoffs and a
collapsed stock market. We live paycheck to paycheck. We're still standing,
but you could knock us down with a feather.
At Texas Tech University, future financial planners are taught
to make an emergency fund a priority for prospective clients, even if it's not
on the client's agenda.
"The client wants you to help them meet their financial goals,"
says Vicki Hampton, certified financial planner and director of the university's
Family Financial Planning program. "But what if a client comes in and says
they need to save for their child's education or a new home? You collect the
data and see that they're maxed out on their credit cards and they have no emergency
"Even though you've been hired to help them meet their goals
and their goals don't say anything about an emergency fund, you'd try to get
them to do that before they work on their child's education or the new house.
We want them to think of the emergency fund as a prerequisite."
David Bohannon, a certified financial planner in Louisville, Ky.,
says getting clients who want to maximize returns to focus on an emergency fund
isn't easy. After all, money that's sitting in a safe, secure fixed income account
earning practically nothing isn't the best way to amass a fortune. Or is it?
"You have to get them to understand the concept of risk,"
says Bohannon. "What if we didn't have an emergency fund and you had to
redeem some of your equity positions at the low water mark of the stock market?"
Bohannon is a proponent of building an emergency fund consisting
of three to six months of living expenses, and a contingency fund that can support
you for up to two years if you should lose your job. The emergency fund should
be kept in cash, but the contingency fund can be invested in short-term government
bonds or other instruments that are considerably less volatile than the stock
"An emergency fund isn't something that's done immediately,"
Bohannon notes. "Just like a financial plan isn't done immediately. We
start the process of regular investing."
Many financial planners will tell you that the success of any
long-range saving plan depends less on the rate of return than on consistently
putting money away and leaving it alone.
Treat the emergency fund as a bill. Pay your account every month
or every two weeks.
Retirement accounts are successful because the money comes out
of your paycheck before you can get your hands on it, and because there are
taxes and penalties for early withdrawals.
Stashing money in an easy access money market account takes discipline.
"Once you've got the money in your checkbook, there are all
these demands coming at you -- the mortgage, taxes, the kid's braces, McDonald's,"
says certified financial planner Chris Cooper of Toledo, Ohio.
"Then we have this idiot box, the TV, with somebody yelling,
'Zero-percent interest, buy this now!' People get overwhelmed. They know they're
not supposed to spend the money, but they do."
As you're growing your emergency fund, consider keeping it in
a money market account or fund until you have about two months of living expenses.
Move one month of expenses to a one-month CD. When the CD matures, roll the
principal and interest into another one-month CD.
All the while, continue making regular payments to the emergency
fund money market account. Eventually you'll have another month of living expenses
that can be used to invest in a two or three-month CD.
If you are opting to set aside six months of expenses, continue
the process until you can comfortably purchase a six-month CD.
There's a good reason why an emergency fund should equal three
or six months of living expenses instead of income. Your income may not meet
your living expenses, or it may exceed your living expenses. You may be able
to keep a smaller emergency fund on hand if you have some expenses you can live
without, such as a daily $3 latte.
Whatever financial shape you're in, the first step toward building
an emergency fund is to figure out where your money is going, according to Tom
Grzymala of Alexandria Financial Associates in Alexandria, Va.
"People don't know where they're spending money," says
Grzymala. "If they're bringing home $70,000, they can only account for
"Generally, maybe 20 percent of the folks have a handle on
what they're doing financially. Many don't have the foggiest. Use something
like Quicken to keep track of where your money is going. It tells you whether
it's going to food, clothing, shelter or pizza," adds Grzymala.
After seeing where your money is going, it's a lot easier to decide
where you can cut. But if you're worried about losing your job soon, you may
have to build an emergency fund a lot faster than you can simply by cutting
Taking a loan from your 401(k) to quickly build an emergency fund
is a bad idea. If you lose your job, you'll have to repay the loan immediately
or pay taxes and penalties on the amount withdrawn.
A controversial move that may be appropriate if you're fairly
young is temporarily stopping payments to your retirement account.
"Contributions to a retirement fund are important,"
says Grzymala, "but I'd rather have three to six months cash reserves than
borrow from a 401(k), lose my job and then have to pay the penalties."
Some experts say they'd only stop contributions as a last resort.
You'll miss out on the tax-deferred growth and you may be giving up a matching
contribution from your company.
Another consideration might be your Roth IRA. You can withdraw
contributions at any time without penalty. Unfortunately, you can't replace
that money because Roth rules limit contributions. But using those funds could
get you out of a temporary bind without resorting to more drastic measures.
Tapping any retirement account for emergency funds is something
you want to avoid unless there are no alternatives.
If a layoff or some other emergency isn't imminent and you have
time to build your fund by reducing expenses, here are some tried-and-true budget-trimming
suggestions from Tom Grzymala that will work for just about everyone.
- Quit using credit cards. Unless you're in the habit of paying
your credit card bill in full each month, don't use the cards for anything
you can eat or wear.
- Interest rates are exceptionally low. Consider refinancing
your mortgage and your car loan.
- If you live in an area that has good public transportation,
see if you can get around without the car sometimes.
- Do an energy check on the house. Replace cracked storm windows
and renew the weather stripping.
- Don't renew subscriptions to magazine or newspapers you're
- Eat out less often. If you stop at Starbucks every morning
for coffee, make coffee at home.
Saving money takes discipline, but it becomes easier over time.
The peace of mind that comes from knowing you have financial resources for tough
times can be worth the sacrifices you make now.
-- Updated: Dec. 7, 2004