Money Management: Why You Need an Emergency Fund
Kiplinger contributing editor Cameron Huddleston learned this lesson the hard way: Everybody needs an emergency fund. She shares her experience here as a vivid reminder of why we all need money set aside for a rainy day.
Why? Because of the chance you could lose your job, or your refrigerator could die, or you might have to get an emergency root canal. And if you don't have enough cash on hand, you don't want to find yourself looking around the house for valuables to pawn, racking up credit card debt or getting a payday loan.
In Cameron’s case, she had a surprise tax bill. Because she got a refund the previous year, she didn't expect to owe the IRS—especially not close to $3,000. Plus, she and her husband had been paying down high-interest debt. That left their bank account balance pretty low at the time their accountant finished their tax returns—only one week before the filing deadline. To top it off, Cameron had a quarterly estimated tax payment due at the same time.
So she wiped out her account to pay Uncle Sam and relied on birthday cash from her mom to buy groceries until her next paycheck arrived. It was a terrible feeling being broke—even if it was just for a few days.
No more excuses
She knows she has only herself to blame. Equal parts procrastination and denial had prevented her from creating an emergency fund.
While her husband was in graduate school and Cameron was the sole income earner, her excuse for not setting aside cash for a rainy day was that she didn't have extra cash (the procrastination part). Once they both were working, Cameron figured they had enough left over in their bank account at the end of every month to cover minor emergencies (the denial part).
Maybe you've been making excuses, too. Here are some common ones, and why they don't hold water.
Excuse 1: I can't afford to set aside money
If you think you don't have any spare cash in your budget to save for an emergency fund, where do you think you'll get the money to pay for an actual emergency? Selling plasma? Hocking all your belongings on eBay? It is better to be safe rather than sorry.
You need an emergency fund the most when you're just starting out or living paycheck to paycheck, says Jan Dahlin Geiger, a certified financial planner with LongView Wealth Management in Atlanta, Georgia. An unforeseen event could devastate your finances and force you to borrow money. You won't get ahead financially if you're in debt, Geiger says.
The conventional wisdom is to have enough set aside to cover three to six months of living expenses. That doesn't mean you have to stash that much cash at once. Nor does it mean you have to have a big salary to have enough to spare for an emergency fund. Saving is a function of discipline, not income, Geiger says.
One way to get started is with a tax refund.
You probably have even more money to spare and don't realize it. If your federal tax refund was anywhere close to the typical $2,500 refund, you probably are having too much withheld from your paycheck. Filing a new W-4 form with your employer to cut overwithholding can put extra cash into your paycheck that you can steer into your emergency fund each month.
Then track your spending for a month to figure out where you can cut back, and divert that money to your emergency fund. If you have direct deposit at work, you can have your employer deposit a portion of your paycheck into a savings account.
Excuse 2: I can use a credit card for emergencies
You can always use a credit card in a pinch, right? Wrong.
While in college, a friend gave Cameron a ride home during a school break and his car broke down while we were driving across southwestern Virginia. It was a small town with only one mechanic—who didn't take credit cards. Her friend used his debit card to empty out his account, but it wasn't enough to cover the bill. So he had to leave his hunting bow as collateral until he came back with more cash on his return trip to the university.
You can't always count on your credit cards as your emergency source of cash—nor should you. If you use a credit card for an emergency, Geiger says, "What you're saying is you want to tread water financially. That's why you have an emergency fund—so you don't have to use debt."
For example, if you charged $1,000 to a credit card with an 11 percent rate and paid just the minimum each month ($40), it would take you six years to wipe out your debt and you'd pay about $258 in interest.
Excuse 3: I have other sources of cash
If you think your retirement account is a good source of emergency cash, think again. You'll pay penalties and taxes at your income-tax rate if you tap your IRA or 401(k) before retirement.
For those of you relying on a home equity line of credit, be careful. If you already have a line of credit, it might not offer as big of a cushion as before because of falling home prices. You may have been approved two years ago for, say, a $50,000 line of credit. But now you might have just $10,000 in equity to draw against.
If you don't have a line of credit but "are dependent on being able to borrow money on a moment's notice, you could be in for a rude surprise" says Greg McBride, CFA, senior financial analyst at Bankrate.com. Lenders are offering fewer lines of credit or freezing them altogether, he says.
The only people who should be relying on a home equity line of credit are those whose only debt is their mortgage and who will be disciplined enough to pay off the line of credit as quickly as possible, Geiger says.
Where to put your money
The place to park emergency savings is in a bank money market or savings account, McBride says. The interest rates on these accounts are not great now, but your principal will be safe and you'll be able to access your money easily. "You're not putting money into a savings account to make you rich," McBride says. "You're putting money in the savings account because it's a buffer from high-interest rate debt when unplanned expenses arrive."
You can search the Web to find money market and savings accounts with the best rates in your area.
Some online banks don't provide ATM cards and checks for their interest-bearing accounts—only online transfers to your regular bank account that can take a couple of days. So if your car breaks down in the boonies, an emergency fund stashed in such an online bank won't be of much use.
Some financial planners recommend money market mutual funds. But these come with fees and minimum investment requirements. For example, Vanguard, which has the lowest fees in the industry, has an average expense ratio of 0.14 percent on its money market funds, a $20 annual fee on accounts with less than $10,000 and requires a $3,000 minimum investment.
So no more excuses. Cameron stopped making them and opened a money market account after that surprise tax bill. Now it's your turn to open an account today and start saving so you'll be prepared not if, but when a rainy day comes.