Building an emergency fund

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Funneling money into an emergency fund is like going to the dentist. You know you should do it but, um … maybe next month.

When’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 fund.

“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 market.

“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 $50,000.

“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 expenses.

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 not reading.
  • 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.

• Just say no to renting
• Secure your future
• Cut your expenses by 10%
• Find a job you love
• Goodbye debt hassles
— Updated: Dec. 7, 2004