Standard financial advice says you should squirrel away cash for emergency expenses.
That’s easier said than done for many American families that face competing money demands. The financial guidance also leaves many consumers confused, because specifics about emergency funds, including what exactly they are and how much is needed, vary widely depending on who is giving the advice.
“Nobody thinks they’ll have an emergency until it happens,” said Chris Long, a certified financial planner at Long & Associates in Chicago. “There are certain unforeseen expenses that happen with everyone.”
A study released last week by Bankrate.com found that only 24 percent of Americans have saved six months’ worth of living expenses, and 24 percent have no emergency savings at all.
“The majority of Americans still have much work to do in building an adequate emergency savings cushion,” said Greg McBride, senior financial analyst at New York-based Bankrate.
So, how do you build an emergency fund when you’re supposed to be socking away for retirement, paying down debt and trying to save for your child’s college education while also putting food on the table and making sure the lights are kept on? Is it as simple as leaving cash sitting in an account?
Here are answers to questions about creating and maintaining your cash stash.
HOW MUCH DO I NEED? There are two basic levels of emergency funds:
Many financial experts say you need an emergency fund to pay for unexpected costs, such as a car repair, dental treatment or airline ticket to see a gravely ill relative. With cash on hand, those expenses won’t end up on a credit card, potentially racking up interest and making the expense far more costly. A relatively small cash hoard of $500 to $1,000 typically is sufficient to pay for unexpected expenses. At the very least, it limits the amount a consumer has to borrow.
And it’s doable for a lot of people, said Liz Weston, author of “The 10 Commandments of Money: Survive and Thrive in the New Economy.”
“That’s a very reasonable goal; $500 is a number most people can get their minds around,” Weston said. “That will cover a lot of the little setbacks like a small car repair or emergency plane ticket. It puts you ahead of the paycheck-to-paycheck rat race.”
A whole different level of emergency stash is a lost-job fund. This allows a household to stay financially afloat for several months after a breadwinner loses a job.
This is where people’s needs for an emergency fund diverge, depending on circumstances. A one-earner household with income of $80,000 a year is more vulnerable after a job loss than a household with two $40,000 earners. In the first case, all income is lost, save for unemployment checks. In the second, half the household income is lost, since both earners are unlikely to lose their jobs at the same time.
Conventional advice says a full emergency fund should equal three to six months of living expenses. Practically, that can be three to six months of bare-bones expenses, because a household in crisis presumably would cut back on all expenses but necessities. That dollar figure can equal three to six months of covering the rent or mortgage, feeding the family and paying for electricity and gasoline.
The Bankrate.com survey found that 46 percent of respondents have at least three months of expenses socked away, and 22 percent have savings to cover fewer than three months.
One-earner families should aim for six months of savings, and those with multiple earners can get away with less, experts generally say.
High-income individuals probably want an even larger emergency fund, because it typically takes longer to find higher-paying jobs, Long said. People making about $100,000 a year should have nine months of emergency savings, he advised, and those making $250,000 should have 12 months.
“A year in an emergency fund, that’s the ideal,” Long said.
Another way to calculate the needed total is to plan for the number of months a laid-off person in your industry typically takes to get a new job.
“You have to plan for what’s happening at your job level,” said Julie Murphy Casserly, a financial planner in Chicago and author of “The Emotion Behind Money: Building Wealth from the Inside Out.”
WHAT CONSTITUTES AN EMERGENCY FUND? Cash is certainly the central component of an emergency fund, and some experts argue it’s the only one. Others have a more liberal view, counting credit as part of the fund. Examples are unused credit on credit cards, home-equity lines of credit (HELOC) and even borrowing from family.
The idea is that during a time of financial crisis, especially a job loss, you would use every source of money you have.
“While saving up that money is important, the thing that saves us a lot of times is access to credit,” Weston said.
Even so, aiming to have a significant cash stash is important.
“I still would eventually want that cash,” Weston said. “I wouldn’t say, ‘I have a HELOC; I don’t need to save anything.’ “
Another reason to have cash is that fewer people have access to credit now that lenders have cracked down on who they lend to and how much.
“For a time, people couldn’t imagine a world where credit wasn’t available to them. We’re in that world,” Long said.
And, as happened during the recent financial crisis, banks can decide to reduce limits on credit accounts or eliminate them altogether.
“You cannot count on them as part of your emergency fund, because a lender can lower the limits at their discretion,” Long said.
For a different reason, Casserly doesn’t like to count credit in the emergency fund.
“Debt is a runaway train,” she said. “Once they tap it, it’s really hard to get out of that cycle. They create a lifestyle of having debt.”
WHERE DOES IT RANK AMONG MONEY PRIORITIES? If you’re in imminent danger of losing a job, piling up cash must be priority No. 1.
If your job is relatively safe, you might use a two-tiered system: First, build a small fund of $500 to $1,000 to pay for unexpected costs. Then build a three- to six-month emergency fund while working on other priorities.
Starting retirement savings also should be a priority, because it takes so much money to build a nest egg, and the longer you put it off, the harder it is to catch up, Weston said.
“Retirement comes first, no matter what’s on fire at the moment,” she said.
And if your employer matches your contributions to a retirement plan, it makes sense to contribute at least enough to get that match. That’s like a 100 percent return on your money.
After that, pay toxic debt, such as high-interest credit cards and payday loans.
Once you’ve eliminated consumer debt — probably excluding a mortgage and low-interest student loan — you have flexibility to spread money to other priorities, such as children’s college accounts. Ultimately, though, the goal is to return to cash-stacking in the emergency fund.
“It does depend on individual situation,” Long said. “If somebody has a (401(k) retirement) match, that’s a different answer than if they have no match. It depends on if they have a little credit card debt or a lot, if their salary is high or low, if discretionary spending is high or low. It’s hard to give a one-size answer that fits” everybody.
Casserly said she likes to tell clients they should work on equally paying for the past (in the form of debt), paying for present expenses and saving for the future.
“They have to hit all cylinders at the same time,” she said.
WHERE DO I KEEP MY EMERGENCY MONEY? Many financial advisers suggest opening a separate bank account for your emergency fund. That stems from a consumer-behavior phenomenon known as “mental accounting.” A separate account helps consumers mentally acknowledge that the money is off-limits — different from slush-fund money in checking or savings accounts.
Weston believes an online bank is a good place to stash emergency money. Not only will you get a little better interest than at a brick-and-mortar bank, but it also takes a day or two to transfer money out.
“What tends to help is to put the money someplace where it’s inconvenient to get it,” she said. Examples of online banks that are consistently recommended are INGdirect.com and EmigrantDirect.com.
Casserly said she advises her clients to set up separate accounts for an emergency fund, and even other spending goals, such as a new-car fund and a house maintenance fund.
“The intention is clearly laid out so that they’re less likely to use it for other purposes,” she said. “That has really helped keep people honest with their money.”
Long also likes the idea of making the money less than accessible.
“The idea is to stick it in there and forget about it,” he said. “If people see money there, they will spend it on something that’s not an emergency.”
And don’t worry too much about leaving your money in a bank account that pays little interest. You should look at the emergency fund more as insurance than as an investment requiring a decent return.
“I know people want to maximize everything, but what they don’t understand is that maximizing increases risk,” Long said.
Emergency money should not be in the stock market or other potentially perilous investments.
“This is money that isn’t supposed to be at risk. It needs to be there for you in case something bad happens. You can’t play with it,” Long said.
WHERE DOES THE MONEY COME FROM? One key is to contribute regularly to the emergency fund. Set funding on autopilot, Long said.
“Even if it’s only $25 or $50 a paycheck, have it automatically transferred to an account,” he said.
Financial windfalls are great ways to seed or boost the balance of an emergency fund. They include a tax refund, a cash gift or the savings you reap because a child goes to school and you’re spending less on day care.
Simple budgeting will usually reveal plenty of money leaks that could be funneled into an emergency fund, Casserly said.
WHAT SHOULD AN EMERGENCY FUND BE FOR? This is one of those “know it when you see it” decisions. It will be an unexpected expense that’s so important, you would charge it on a high-rate credit card.
“They are usually things you don’t have options about, and if you don’t spend the money, the consequences are huge,” Long said.
Vacation spending, upgrading your kitchen countertops or buying a new car because you’re tired of the one you have are reasons that don’t qualify.
“It’s something not normal in your monthly cash flow,” Casserly said. “It’s something that means your family would truly be hurt if they didn’t have it.”
A nonfinancial benefit of an emergency fund is its psychological component. Having a cash reserve can provide peace of mind, Casserly said.
“They’ll make decisions very differently,” she said of people who maintain a cash stash. “They’ll start to feel empowered and move away from a victim mentality. It’s unbelievable how it changes their demeanors. They’re happier, and they feel in control of their lives.”
(Sandra M. Jones of the Chicago Tribune contributed to this report.)
Source: McClatchy-Tribune Information Services.