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Financial meltdown: emergency funds

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Biggest mistakes

Natural-born savers are spared a lot of agony when financial emergencies crop up. That skill doesn’t come easily to everyone, though. Spenders can often forget about the importance of saving money for a rainy day.

When it comes to emergency funds, not having one at all is the biggest mistake consumers can make. When something goes wrong, and something always will, relying on credit to get you through the situation can backfire.

Credit does make a great backup tool, but having a solid cushion of cash protects your financial security and saves money that’s otherwise wasted on finance charges.

But simply not having an emergency fund isn’t the only way to go wrong with this personal finance fundamental.

“Emergency funds are not very complex. The key to them is to have them segregated from other investments as well as one’s personal checking account, and maintain guarantee of principal,” says Mark LaSpisa, a Certified Financial Planner with Vermillion Financial Advisors in South Barrington, Ill.

The other mistake that people make with emergency funds is they focus on yield when investing the principal. “The key concept behind an emergency fund is liquidity. The rate of return on the principal is minor,” LaSpisa says.

Emergency funds should be easily and freely accessible. Though investments such as CDs may offer a better interest rate than a plain old savings account, you may have to lock in for a year to get a worthwhile yield. Then you’ll have to fork over some money and pay a penalty to get it out early.

Investing in mutual funds is also a common blunder. Even the safest investments are subject to fluctuation.

“Investors put their emergency fund in bond mutual funds — including government bond funds — and don’t realize that there is a possibility of NAV (net asset value) erosion,” LaSpisa says.

Even if your emergency is safely tucked away into a savings account, it can still be worn down through lack of discipline.

To maintain a healthy store of cash, consumers have to keep their hands out of the cookie jar. It’s only a matter of time before something goes kaput, whether it’s the car, the microwave or the economy. Having a little money between you and the catastrophe of the day can greatly enhance your peace of mind.

Smart strategies going forward

Despite the fact that the economy falters, stumbles or crashes with some regularity, every time it happens it comes as a complete shock. Equity positions are rashly abandoned, hands are wrung, dire predictions about the end of Western civilization become the norm and then gradually everything resumes equilibrium.

Then we return to our profligate ways after vowing to never make the same mistakes again.

With ample credit and a zooming economy, the priority of funding a healthy emergency fund can fall by the wayside for some consumers. But that is when it is most important to save regularly — when things are going well. By the time the sky has fallen and you realize you need some cash, it’s too late.

“Often when times get better, people lower their emergency levels as their fear goes away, and when times are bad they raise them. But it should be the opposite,” says Carlo Panaccione, Certified Financial Planner and president of the Navigation Group in Redwood Shores, Calif.

Now that Ben Bernanke has officially announced that the recession is probably over, it’s a great time to get your emergency fund started. To do that, open a new savings account completely separate from other checking and savings accounts you may have. It doesn’t have to be brimming with money right away. Begin contributing as much as you can regularly — whether that’s $10, $20 or $50 per pay period. Any start is a good one. Doing it regularly is key.

When you get a raise, a bonus or a check from Grandma, funnel a portion of that windfall into your emergency fund.

“Try not to order checks or debit cards for this account, and forget you have it until a real emergency hits. Then have the discipline to replenish it or sometime in the future you will have nothing left in the account,” says LaSpisa.

Many experts suggest that you shoot for at least enough money to cover three to six months of expenses.

Panaccione recommends looking at the big financial picture before sticking all that money into a low-yielding savings account.

“If you have good disability insurance and you have good health insurance and you have a stable job, you probably don’t need the same emergency fund as someone who has no health and disability insurance,” he says.

How much you decide to save will depend on your fear level and the type of emergency you anticipate. No matter how much that is, the key to maintaining a healthy emergency fund is to pretend like it doesn’t exist until an emergency.

Still not convinced? See Bankrate’s Financial Literacy story on why you need an emergency fund.

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