With my daughter going out on her own, we spent time talking about creating an Emergency Fund and what it is and what it should be used for. Below is an interesting look at what one advisor is doing with emergency funds.
The Fantastic Life Rule #5: Make Sacrifices
This rule shines light on the fact that no matter how small or large, sacrifices are necessary for you to live life fully, as well as be prepared for whatever it may hold for you – good or bad.
Fresh Look at an Emergency Fund
One adviser favors a cash fund that is used more frequently and funded regularly
JOURNAL REPORT: WEALTH MANAGEMENT September 18, 2013, 5:27 p.m. ET
A Fresh Look at an Emergency Fund
When real-estate prices were skyrocketing in the 1990s and 2000s, the idea of stashing away three to sixth months worth of income in cash seemed wasteful to many investors. As a result, people started relying on their home-equity line of credit and credit cards to pay for emergency expenses. That’s exactly what got many people into trouble in 2008. Some investors lost their homes, their jobs and their savings all at once and had nothing to fall back on.
It’s important that advisers talk to clients about emergency funds. When a client doesn’t have an emergency fund, taking on debt becomes the only way to pay for unexpected but necessary expenses. The traditional role of an emergency fund is to provide three-to-six months of income for a family or individual in case of a financial catastrophe.
It’s usually a cash account, funded up front and designed to deal with only the most extreme emergencies. Most of the time the cash just sits there. But I’ve come to believe in a more dynamic sort of emergency fund, one that should be used more frequently and funded regularly.
I think emergency funds should be used to pay for any important but unforeseen expenses, such as a repair to a leaky roof, replacing a worn-out car, or covering medical deductibles—not just in absolute worst-case scenarios.
The idea is for clients to fall back on cash rather than credit cards when they go over budget. So, although the emergency savings isn’t generating much interest, it enables the client to avoid taking on credit-card debt. From a growth perspective, avoiding paying interest on debt is just as powerful as generating returns on investments.
I recommend clients start with enough emergency funds to provide six months of income, and that they contribute 2% of their income to the fund monthly, much like with an employee benefit plan.
That may be difficult to do in the short term, but it will pay off in the long run. In addition to providing savings on interest and long-term financial security, an emergency fund provides peace of mind, which for many clients is its biggest benefit.