We’ve all experienced Murphy’s Law at numerous points in our life and when it happens in our finances, it can be particularly painful. Often, the best defense is an emergency reserve fund you can turn to in a time of financial crisis. But, how much is enough and what’s the best way to set it up? The answer to this question will be different for just about everybody but here are some guidelines that can assist you in designing your own customized emergency reserve fund.
- Deciding on your emergency reserve fund goal. Financial advisors typically suggest building an emergency reserve fund equal to three to six months of family expenses (your average monthly bills times three to six months). This is a good starting point and I would suggest that you customize your answer by taking a close look at your own facts. If you were to lose your job, how long would it likely take you to find another job of equal or higher pay? For example, if you are an engineer or an accountant, jobs are relatively plentiful. The same is true for salespeople who have good work experience. In these cases, you might feel comfortable with two to three months of reserves. If you’re in a job where it’s hard to find a replacement, you may want an emergency reserve of a year or more. Take a realistic look at your situation then set your goal.
- Automate your success. People often comment that they have very little money for savings. My wife likes to use a phrase, “Bloom where you are planted!” In this case it means, “Start where you can afford to start…but start somewhere.” Now that you have your goal, set up an automatic transfer from your checking account (or paycheck) to a separate emergency reserve account. It matters more that you get started rather than how much you are saving each month. Success tends to encourage greater success so start where you can and bump up your savings when you can.
- Best place to save. What’s most important is that you have easy access to your funds. Remember, this is for ‘emergencies’ which by definition means it will be unexpected. In the low interest rate environment that we find ourselves today, there are no great choices for earning anything but anemic interest rates. Your best choices are a money market account, credit union savings accounts or similar easy-access accounts.
- Best way to use the account. Be clear that this account is for emergencies, not to fund a better vacation than you otherwise couldn’t afford. One strategy that is worth considering is to continue to automatically deposit funds in your emergency reserve account once you’ve hit your goal. For example, assume you’re saving $100 per paycheck and your goal is to build an emergency fund of $10,000. Once you hit that goal, continue to automatically invest your $100 per month since you’re already ‘in the habit’. You can use your ‘excess’ funds for non-periodic bills or purchases. Always keep an eye on maintaining your target account value. If an emergency expense takes you below that amount, focus on rebuilding your account.
- Your backup plan. One thing we often recommend is setting up a home equity line of credit as a backup emergency reserve account. The advantage is relatively quick access to cash for an emergency and typically little to no costs to set this up. The disadvantage is if you use it, you’ve created debt that must be paid back so you have to be very careful and diligent.
One byproduct I find with folks who have strong emergency reserves is greater financial self-confidence. It’s hard to describe it, but it’s there none the less. You know you need emergency reserves…take action today by setting up an automatic deposit account and the next time Murphy raises his head, you’ll be ready!