Creating a financial cushion for stressful times

BUILDING AN EMERGENCY FUND

How would you respond to sudden financial demands?
We all define “emergencies” differently, but we are not immune to them. How can
we plan to stay afloat financially when they occur?

Most households are not financially prepared for
an emergency – not even close. A recent study from the National Foundation for
Credit Counseling found that 64% of Americans had less than $1,000 in funds
earmarked for a crisis.1
While the recession did its part to siphon
emergency funds from families, attention must be paid to rebuilding those
funds. It may be difficult; it may be inconvenient. That doesn’t make it any
less of a priority.

Emergencies tend to be linked to long-term debt.
Having a designated emergency fund can help you attack that debt. When most
people think of financial emergencies, they think of medical problems and
burdensome costs that their insurance won’t fully absorb – but there are other
paths to long-term debt, such as a sudden layoff, a natural disaster, a family
issue with financial underpinnings or even an abrupt need to move to another
metro area, for whatever reason.
How large should the fund be? You decide. An old rule of
thumb is six months of net income or six months of expenses. If you are
snickering or laughing out loud at your chances of saving that much, you aren’t
alone. If your prospects of building a five-figure emergency fund seem remote,
try to create one equivalent to two or three months of net income. Any amount
is better than none.
How do you do it without hurting your standard of living?

Few of us have a lump sum we can just reassign for emergencies. So consider
these subtle savings opportunities.

> You could pay cash whenever possible, opening
the door to incremental savings that credit card companies would otherwise take
from you. A few dozen bucks can become a few hundred bucks, then a few thousand
bucks over time. Incidentally, in a nationwide survey conducted by Chase
Blueprint and LearnVest, 31% of people polled cited credit card debt as a major
barrier to achieving financial objectives. The credit card debt carried by this
31% averaged about $5,000. Clearly, living on credit cards will thwart your
effort to build a rainy day fund.2

> You could vow not to spend frivolously, thereby
retaining money you might be tempted to throw away on impulse.

> You could sell stuff – stuff somebody else, maybe down
the street or across the country, might want. Incidental shipping and handling
costs could seem irrelevant next to the cash you generate.

> You could arrange direct
deposit or start a seasonal savings account.
The psychology behind both moves is simple: you
are less likely to spend money if it doesn’t pass through your wallet.

Here’s how not to do it.
Try to avoid building a crisis fund through self-defeating methods. For
example:
> Don’t start an emergency fund with a loan. Do
it with your own accumulated savings, bonus money from your job performance,
royalties – whatever the origin, use money you have made or and/or saved
yourself, not money you have borrowed from lenders or relatives.

> Don’t do it using payday loans or cash advances. High-interest
short-term loans and cash advances on credit cards are often pitched as rescues
to struggling households. Thanks to their absurd interest rates, payday loans
are not financial “life rafts” by any means. Cash advances on credit and debit
cards come with disproportionately high fees. Sadly, people who go in for these
loans and advances once commonly go in for them again.
> Don’t refrain from paying certain bills.
Let’s say that you have eight debts you have to pay per month. If you only pay three of them
each month and carefully alternate which debts get paid down, can you create an
emergency fund with the money you avoid paying? Well, yes – but you may imperil
your credit rating in the process.
If you don’t have a designated emergency fund, you can build it up in the same way
that you probably invest: a little at a time, with relatively little impact on
your lifestyle. It can be done. It should be done.

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Citations.

1 – www.learnvest.com/knowledge-center/5-ways-to-start-an-emergency-fund/
[8/14/12]

2 – www.foxbusiness.com/personal-finance/2012/11/01/seven-reasons-why-need-to-create-emergency-fund-now/
[11/1/12]