| Emergency and Cash Reserves Emergency and cash reserves should be a high priority for anyone's financial
plan. Why are emergency and cash reserves important? No matter how good you are
at budgeting and saving and no matter what your income may be, no one is
entirely immune to financial emergencies and even a crisis that may push us
outside our normal financial behavior. The only way to adequately prepare for
these unforeseen circumstances is by accumulating enough to see you through
these irregular times. Accumulating emergency and cash reserves that are stable
(will not fluctuate in value and have little to no risk) and are liquid (easily
and rapidly accessible) is the foundation of yur financial health and should be
one of the first steps of your financial plan.
Why are emergency and cash reserves important?
A financial hardship or crisis is closer than most people would like to
admit. A big part of your financial fitness and your solvency is being prepared.
Sure, a big part of preparing for unexpected events is being properly
insured. Beyond that,
however, we want to ensure we have enough liquid assets to prepare for uninsured
events that prey on our assets. nothing can derail your financial plans and
health faster than being underinsured or not having adequate cash reserves.
Those who are unprepared are then forced to borrow at potentially high interest
rates, liquidate assets such as stocks, bonds, mutual funds, or even real estate
assets at inopportune or even bad times. Doing so could cost you a lot more than
had you created a reserve account.
Think of some of these events and ask yourself if you would be prepared:
- You are laid off, down-sized, or redeployed to a lower paying job
- Your spouse lost there job or was in a serious accident that left them
unable to work
- Your car needs serious repairs and you do not have access to it for
several weeks
- A loved one is hospitalized and you are forced to miss work for several
weeks
- An unexpected family emergency or death that requires time and money to
handle
The bottom line is to have adequate, liquid cash and emergency reserves to
handle most, if not all, unforeseen circumstances that may arise.
How much?
When determining how much to keep in your emergency reserves account, most
financial planners and other experts will agree that it depends on your
particular circumstances. However, it is usually safe to earmark at least three
to six months of living expenses. Of course, you should know this with certainty
if you are tracking you expenses and budgeting
diligently each month. With any planning, it is always safe to err on the
conservative side so closer to six months of living expense may be appropriate.
You also want to consider boosting this amount if you have any known, larger
nonrecurring costs such as a large vacation, family reunion, wedding, home
acquisition or upgrades, new vehicle purchases set to occur in the next near or
so. These short-term expenses should be kept separate in an emergency and cash
reserve account since not enough time is available to incur much investment
risk. A few other things you may want to consider are things such as:
- Limited jobs in your area
- Ongoing medical conditions that require care and medicine
- One-income households
- One or both partners working on commissions or irregular salaries tied
to performance
- Poor overall national and/or local economies.
These are but a few examples of why more emergency cash reserves may be
appropriate. Again, it all depends on your unique circumstances.
Where?
Many people often think and feel that they are losing money buy keeping a
fairly significant amount of money in cash. Although the industry refers to them
as "cash" reserves, this particular fund does not have to be strictly cash. In
fact, it is usually a good idea to find some high-yielding instruments that pay
you a little more on your otherwise idle cash. Remember, however, that the
importance and function of your emergency and cash reserves is not growth.
Instead, it is paramount to ensure they are liquid and stable. Stable and liquid
instruments are really going to limit your options to Bank Certificate of
Deposits (CDs) or Money Market Mutual Funds. Both offer the liquidity and
stability you need, but pay more than any checking or savings accounts.
What if you are in debt?
If you have some or a lot of consumer debt it can be confusing where to
start. Just remember that if you do not have emergency and cash reserves,
incurring more debt may be your only option. Building your reserves may take
priority, but you can successfully handle both with a little hard work and
determination. One suggestion may be to start accumulating your reserves while
paying off debt at the same time. An example of a schedule may looks like this:
- 80% toward reserves - 20% toward debt until you save a
month’s worth of expenses
- 60% toward reserves - 400% toward debt until you save
two month’s worth of expenses
- 20% toward reserves - 80% toward debt until your save
your target amount (e.g., 3-6 months worth of expenses)
- 100% toward high-interest debt after you build your
reserves and before you start investing
Other options
Oftentimes people believe they need less cash and emergency reserves on hand
because they have other options. With housing prices at unprecedented levels,
many people choose to use a home line of credit or a home equity loan as part or
all of there emergency reserves. It is not highly recommended because, in
essence, you are borrowing more money and reducing your equity should you need
or choose to sell sooner than you thought. If you go this route, please keep
these items in mind:
- Do not use home equity or line of credit for all or even a majority of
your emergency reserves
- Make sure any credit lines are at the lowest interest rates possible
- If you do use the credit line, build it back up by including it in your
budget immediately.
In addition, people may look to credit cards or their 401(k)s as available
options. If you absolutely must use either of these options then you do not have
a choice. If you do, beware to choose the best credit card that offers low
interest rates and no annual fees. If you have to take a loan from your 401(k)
beware that you lose all growth of that money while you are borrowing it, you
may have high origination fees from your plan sponsor, and if you leave your job
for any reason prior to paying it back the loan with be treated as a taxable
distribution subjecting you to income taxes and potentially a 10% penalty.
Either option should only be a absolute last resort in dealing with emergencies
and unforeseen expenses.
Accumulating emergency and cash reserves can seem like a daunting task, but
the rewards are well worth it. Remember to start small, automate is via direct
deposit and other features, and be consistent. Before you know it you will have
achieved your first big step towards your financial security and success.
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