This is a guest post from Gail Vaz-Oxlade, a Canadian financial writer and host of the television series ‘Til Debt Do Us Part.
Experts have been touting the importance of having an emergency fund since Moses was a lad. So why is it that so many people still don’t have enough (or any?) money set aside just in case? Reasons and rationales abound.
“I’m paying off my debt. That’s the most important thing.”
With the amount of debt people are buried in, it’s no wonder people want to get rid of it as fast as they can. But having a single focus is never a good way to create balance. Money in the bank gives you options — ways to deal — so that you can stay on track with debt repayment even when bad things happen.
Having no cash at the ready means you’ll no doubt be forced to use your credit to deal with a broken furnace, unexpected medical bills, or replacing that tire you blew on the highway. Accessible cash means you can keep to your debt-repayment plan and deal with whatever crisis — large or small — that has come knocking on your door.
“I can’t see the point of letting money sit earning next to nothing.”
While it can be a really sad thing to watch thousands of dollars languishing in a savings account, return isn’t the priority with an emergency fund. Access is. Stick that money into the market and it may not be there just when you need it most. Stick it in a high-interest savings account and while you may be irked by the pittance you’re earning in interest, the emergency fund will be at the ready when you hit the wall. The point is to have some wiggle room when the unexpected happens.
“I have $1,000. That’s enough.”
$1,000 may be enough of an emergency fund if you live under a rock. Yes, you’ll need less of a buffer if your home is paid for, you have no debt, you walk everywhere you go, and you’re happy eating ketchup soup three nights a week. If you want a realistic emergency fund – one that actually gets you though the rough – figure our your monthly essential expenses and multiply by six. That’s how much you need.
Unemployment insurance may help fill the gap if you lose your job, but it doesn’t go far. And unemployment isn’t the worst emergency you may face. Get sick and watch your money evaporate. Even if you have good health and disability insurance plans, your cash flow will still take a kicking until your benefits click on.
“Who needs an emergency fund when you can use a line of credit?”
The people telling us to get an LOC is an emergency fund are the same people who let us buy houses without enough money down, offered us ways to satisfy all your whims while spending money we hadn’t yet earned, and continually raised our limits until many of us had enough debt to bury an elephant.
A line of credit is not an emergency fund…it is debt waiting to happen. If you hit a wall and end up racking up tens of thousands in debt on an LOC, how was that diverting disaster?
The Ways-and-Means Fund
Perhaps the problem with the whole emergency fund thing is that people don’t like to think they’ll have to deal with “emergencies.” It’s not unlike the folks who won’t make a Will because they don’t want to contemplate their demise, or who won’t buy disability insurance because they can’t imagine becoming disabled.
Maybe we’re just calling it by the wrong name. The whole idea of having to deal with “emergencies” can be a real downer. Maybe what we need is nomenclature that sounds far more proactive and positive. We’ll stop predicting disaster and instead focus on the fact that when you have money at the ready, you also have ways and means to deal with whatever life pitches at you.
Hmmm…a Ways-and-Means Fund…cash in the bank that gives us the means so we can figure out ways of dealing with life’s lumps. Your son breaks his arm playing in the yard, and you have the means — the money — you need to take a day off work, get him to the hospital, and cope in whatever other ways you must. Your partner is downsized and you have the means to pay the mortgage and keep food on the table until he finds new ways of bringing home the bacon. You bang up your car, watch your shingles blow off in a wind-storm, or find yourself in the throes of a divorce, and you have the means to keep the financial boat afloat while you find ways to cope with all the other stress in your life.
Convinced that having The Means offers you more Ways of smoothing out life’s bumps? Now it’s just a matter of coming up with the dough. It takes effort to knead intent into action.
Getting started
The best way to create your Ways-and-Means Fund is to set up an automatic deduction from your regular account to a high-interest savings account. If you don’t have much to save, it doesn’t matter — the important thing is just to start…to convert your intent into action. As long as you haven’t started, you’re not creating the means for dealing with what life will inevitably throw at you. Commit $25 per pay to your Ways-and-Means Fund. Once you’ve begun, you’re on your way and then it only becomes a matter of how to boost the amount you’re setting aside to grow your stash of cash.
Most people have expenses they can trim to boost the money going to their Ways-and-Means Fund. Do you buy coffee every day on the way to work? Calculate how much you’re spending, cut it in half, and send the difference to your Ways-and-Means Fund. Smoke? If you smoked half as much, how much would you be able to sock away? Pick up the latest magazine at the checkout counter?
Subscribe to premium cable? Go out for a drink with your friends after work? Buy your lunch at work? Pick up your favorite “stuff” whenever it’s on sale even though you already have 30 pairs of shoes, white shirts, handbags, DVDs, name your vice here. How quickly could you build your Ways-and-Means Fund by focusing on being safe as opposed to being satiated?
If you’re determined to keep all your small indulgences, try the tit-for-tat approach to building your Ways-and-Means Fund. Each time you satisfy a Want, contribute an equal amount to your Ways-and-Means Fund. Not only will it make you really think about whether you’re going to spend the money — in essence whatever you buy is going to cost your cash flow twice as much — you’ll be giving yourself options for the future while you enjoy yourself today.
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I like the idea of keeping around 6 months of expenses in a liquid emergency fund. I also agree that in all likelihood you will be financially better off by using a LOC and putting that money towards your mortgage or investing it. It comes down to whether you want to maximize the return on all of your money or whether you want extra security.
I am currently saving for a down payment on a house. However, I figure that moving from an apartment into a house will cost me about $1,000/month more. So in order to keep the emergency fund at 6 months, I would also have to save $6,000 more in addition to my down payment. I wonder how many home buyers wait until they have saved up 6 months of home owner expenses in addition to the down payment before buying a house. Using that $6,000 to help me get my down payment faster and using the LOC as an emergency fund is starting to sound better and better…
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Jeff, i think most people save up 20% down, and have at least 6 months of reserves before and after buying a home.
at least, most people in San francisco and manhattan do.
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It is not reckless. It is smart. Further, in today’s economy many people who never dreamed of having to file bankruptcy are doing just that.
Moreover, you can in good faith 1) save money in a retirement account, and 2) use credit to try and get you over the hump. The two concepts are not incompatible. If things turn around great, you can use your retirement savings to pay off the credit. If things reach the point of last resort you can file bankruptcy without spending your retirement money. You don’t have to intend to file bankruptcy, to have a plan for the possibility.
The reality is lots of people are not getting back on their feet in months. The older you are the worst the problem is. Financial planning should involve planning for the worst case scenario. The ultimate goal should be to make sure you can feed yourself as long as possible. Over ten percent of the population in Michigan is unemployed. Scary enough those figures don’t include those drawing unemployment.
Lane writes, “IMHO, planning that bankruptcy will take care of your cc’s isn’t a plan. It’s reckless and irresponsible to have that be part of your plan. Bankruptcy should be an option of last resort.”
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@Terrin:
Re “IMHO, planning that bankruptcy will take care of your cc’s isn’t a plan. It’s reckless and irresponsible to have that be part of your plan. Bankruptcy should be an option of last resort.”
Lane didn’t say it, I said it, and directly in response to this (which you said):
“The benefit of using credit is that if things go really bad you may be able to file Bankruptcy if you need to do so and not have spent your savings….That six months of saved income would be exhausted very quickly. If you live off the credit, you can pay it back if things turn around and if things really fall apart you might be able to discharge some of the money in Bankruptcy.”
I find this an irresponsible approach. You are advocating a) keeping yourself afloat through credit and then b) declaring bankruptcy rather than c) touching your savings. (First of all, if you can demonstrate that you HAVE savings, I’m not sure if you can declare bankruptcy).
Of course, it is a given that if you have 6 months of emergency funds, your emergency might not be resolved in six months (all the more reason to have more than six months if you can. But that doesn’t make this “old-fashioned” or impractical advice. The real answer is if you think you need to be prepared for more than six months of hard times, then you better save more than six months of expenses.
I don’t fault anybody who gets themselves into a tight jam and ends up needing to declare bankruptcy. Sometimes life hands you a bad break.
But bankruptcy is admitting that you have spent more money than you have the ability to repay. So you’re going to discharge your debts. Somebody, somewhere, is going to end up bearing the cost of the debts you avoided. Ultimately you will, with things like a severely stained credit rating, and you may find yourself paying back all your debts anyway only under less friendly circumstances (like wage garnishment, unless you then decide the solution is to never go back to work again.)
I just can’t fathom that somebody would think it’s an actual plan to spend your way out of an emergency on credit and then declare bankruptcy, rather than spend funds you’ve purposely set aside for a rainy day.
If you are living paycheck-to-paycheck and can’t set aside much and end up in bankruptcy, I have sympathy with that. That’s hard times coming and going, and I hope they get better for you.
If you can set it aside but choose not to, thinking that you’re going to float yourself on credit instead, then you don’t get my sympathy and have no business declaring bankruptcy.
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@ ResortAtSquawCreekTAHOE
I totally agree with you about people having more money spending more money. But, as I mentioned, it’s far easier for someone earning more to live on less. For example, it’s easier for someone earning 100K a year to live on half their salary and save the rest than it is for someone earning 40K to live on 20K.
But you’re totally right — people don’t live that way. It’s been shocking to see people who earn 10-20 times my salary lose everything in this economy. I’m able to save and have an emergency fund. I guess when you have less, you have less to lose
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To those who claim the idea of an EF is somehow old fashioned, I can say that there are times in true emergency situations when it’s still cash or check only.
We live in a hurricane bait area that got hit hard in 2004. And, oh yeah, lots of non-native pine trees in my neighborhood that will go down in even light tropical storm force winds.
When you’ve got a couple pine trees that ended up on your roof and there’s a perfectly nice tree removal crew with all their licensing and workman’s comp paperwork in order who says that, for $2,000 (cash or check only) they can take care of the trees on your roof then you need to be able to pull the trigger on that right on the spot. Phone and internet service can be kind of spotty when that happens, and even if you get through to your financial services provider, it can take them 48-72 hours to transfer funds into your bank account.
Not good to be playing the game of hoping a funds transfer makes it into your checking account before tree guy cashes the check, and if your only EF is the credit card, then it’s going to take a lot longer and you’re going to be quoted a higher price for someone who takes plastic.
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I don’t agree 100% with Gail’s guest post, but I like a lot of what she said.
In my case my spouse and I have low interest debt (averages 4.22%), and we are focused like lasers on paying it off.
I started with a small emergency fund which was in one month wiped out by car repairs, a blown tire, electrical issues in the house (caused the heat to stop working!), and co-pays from the doctor (after we had maxed out our HSA $.
We now keep $1,000 in it and add to it monthly with the small side income I’m bringing in. By the end of a year it will have grown to $5,000! We are also aggressively paying off our debt (everything but the mortgage), and hope to have it paid off by mid-year next year.
I think our plan is perfect for us. My husband’s job is extremely safe, and even in the case of his unemployment with my small income and his severance we would be fine for 6 months.
After the debt is paid we will breathe a big sigh of relief and start socking away more, but by then our monthly obligations will be significantly less, therefore our emergency needs will be covered much quicker.
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Tyler @27: Unless you’re union or have a contract, there’s no guarantee your current employer will maintain their generous severance policy. A smart firm has it stated clearly that policies can be changed at any time, with or without notice. And in the current economic climate, reduction of generous policies is happening all the time.
It sounds like you have other avenues should you lose your job, so that’s great. But never, ever count on what a company will– or won’t– do for you as protection. Do for yourself.
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beth – you’re exactly right! the less you have, the less you have to lose which is a GREAT thing in the economic downturn. I’ve personally lost probably 400-500K in property/investments in the past 2 years, which is kinda sickening. No matter how much you make, you will still find losing money painful.
I’m a great example of someone who thought the good times would last for a long time, and spent too much. In my spreadsheet, i had an average total income of 600K for the next 10 years, and I thought I was being careful b/c i made 740K 2 years ago. Conservative i was telling myself. In actuality, I think I will most likely average 375K for at least another 2 years, and then perhaps 450-500K for the next 8 years. Good money, BUT, I was living a lifestyle at 600k, but secretly thinking i would be over 700K/yr.
Hence, the more you make, the GREATER your chance to blow oneself up if you will. At 700k, you start thinking 2.5 million house. God forbid you buy the 2.5mil house by putting 800,000 down, and have a 1.7 million mortgage, and then go down to a single income or lose your job!
People with this type of income needs to just set a spending LIMIT every year of say 150K (add your spouses income, and should be over 200K), and then STOP. Bank everything else. Spend your base, save your bonus as they say in finance. These may sound like big numbers, but to live off 200K between both people in cities such as SF or Manhattan is very frugal.
In a downturn, feel lucky you have relatively little. Use this downturn as an opportunity to get leverage for the inevitable upturn!
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I have as secure a job as anyone can have, but nevertheless have built up an EF of $11,000 over the past couple of years.
For me, the point of the EF is my 87-year-old father. Over the years I’ve come to realize that in spite of what he says, he hasn’t been particularly good with money. It’s not that he’s overspent, but it’s more that he hasn’t saved much at all, and tends to spend his money on “bargains” that he really doesn’t need. He stays within his budget, but still has a mortgage (claims it was money-smart not to buy the house outright), has a bit of cc debt and other “lines out in the sea” (he’s a strong believer in having and using credit, etc.) His net worth is primarily in his home (in Florida), whose value has fallen a bit. So, I’m quietly trying to prepare for a problem, just in case. And in any event, I’ll have to manage affairs when he gets sick or passes away. Best to have some cash at the ready.
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I’m glad that I had an EF when I had some car damage last year. Unfortunately, I had more damage and that went on credit because the EF was drained. I actually had to raid some other funds also, and I am now building it all back up again.
I have an OLOC that I set up when I stupidly mangled some numbers and was about to go negative. I’ve triggered it three times, the last two for less than a dollar each time. The 23 cents I’ve paid in interest beats the $100+ the bounce fees would have cost. But I don’t think of it as an emergency fund. I think of it as a bad math consequence mitigator.
My EF has just creeped above $100 and is climbing up again, I just hope that nothing else expensive happens before I get it to a reasonable level.
I try to plan my finances on the assumption that I could be unemployed tomorrow. (Not too likely, given that I have two departments arguing over who I should work for, but there are no guarantees.) I spent over a decade digging out of a credit hole, and I’m not going in again if I can help it.
I keep my EF in my ING savings, it is a line in my spreadsheet that divides the account into sub-accounts for various purposes. With an Electric Orange account and ATMs nearby, its about as liquid as anything else.
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MikeVx – did u say your emergency fund has only $100 in it? I’m sorry, but you’ve got to boost that to like $2-3,000 at least, or at least 1 month’s salary. I’m assuming you don’t make under $1,000/month, and apologies if you do. Best
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The importance of an emergency fund can never be stressed enough! Thanks for this post.
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