Saturday, February 1, 2014

The Emergency Fund -- Again

A new report from the Corporation for Enterprise Development finds that 44% of American households have less $5,887 in savings for a family of four. The same report notes that 56% of Americans have subprime credit ratings. In case of an emergency these families will be forced to rely upon high interest credit cards or payday loans that will keep them in debt, sometimes for months at a time.

Nearly ½ of American families are living paycheck to paycheck. It is not only the improvised who are considered “liquid asset poor.” Approximately ¼ of middle class households fall into the same category.

It isn’t just the poor and the middle class who are playing with fire. Let me take a minute and introduce you to a power couple who live, as I once did, in the suburbs of Washington D.C. We will call them Jack and Jane. Jack just turned 40. Jane is still in her thirties, just barely. They live fairly near my church in a house valued in excess of $650,000, although they still owe a little over $700,000 on that property. Together they earn a little more than $175,000 a year. She is a biotech researcher, works at NIH. He is a middle manager at a major investment banking house. With two mortgage payments, a leased Lexus SUV, payments on a new Chrysler mini-van, and credit card debt if one of them looses their job, the family would be in trouble within six months. They have essentially no savings. If they were to both loose their jobs, the family would be in bankruptcy court within three months.

Living in the Washington D.C. area during the real estate bust of 2006 followed by the crash of 2008, I saw quite a few McMansions go into foreclosure auctions. I also expect more than a few of those leased SUVs parked in their driveways were hauled off by the repo-man.

Every six months or so, I see the results of a new report (like this one) that indicates the lack of an emergency fund is a pervasive and persistent problem.

So—One More Time:

Rule seven of my basics for young couples states, “Start a “rainy day” fund in a bank or a money market fund. The goal here is six months cash reserve (six months take home, both salaries). It will take some time to reach this goal. Don’t beat yourselves up about this but keep putting a little something aside every month.”

This emergency fund is the critical beginning to financial freedom. Start by living on less than your take home pay. Put the difference in a savings or money market account at an insured bank or credit union. These dollars are not for the purpose of investment. They are a life raft that will keep you afloat if something happens to sink your ship. The goal is that every month you place 10% of take home pay into savings before any of that money is spent. It won’t be easy but even the first $1,000 will protect you from flat tires, dead washing machines, and similar everyday real world problems. If you can pay cash, you will not be victimized by the credit card companies or worse, payday loan companies.

If you have less than $1,000 in a designated emergency fund, consider that an emergency. Cut your expenses to bare necessities. Hold a yard sale. Take a part time second job for a few months. Do something. Start today. It is that important for your family’s survival.

Use the emergency fund for emergencies, never for anything else. If there is any other way to pay for something other than debt, don’t tap the emergency fund. As you build up savings for special purposes, such as automobile repair, vacation, Christmas, and medical expenses you will be less likely to need money from the emergency fund.

Consider the emergency fund one of your top priorities until you reach that six month mark. Even if you don’t have a completed emergency fund, continue to make any 401(k) contributions that will be matched by your company. You simply can not beat a guaranteed tax-favored instantaneous 100% return on your investment.

When is the emergency fund sufficiently large to begin a fanatical effort to pay down your credit card debt? This is a matter of debate among personal finance authors. The low number is $1,000 in the emergency fund—then a full bore attack on your credit cards. The high number is eight months of living expenses before attacking high interest debt. It is your life. You need to make a reasoned decision based on your job security, controllable versus uncontrollable expenses, and the size of and interest rates on your unsecured debt. Personally, I think $1,000 is too low and eight months is way too high. If you have a good secure job, perhaps 2 months take home might be a good point to switch gears from defense to offense. If you are worried about the future of your job, you might want to exercise more caution, perhaps 4 months in the bank before a full frontal assault on your debts. Of course you can choose to strike a balance between building an emergency fund and paying down debt at the same time, but only after you have a balance in the emergency fund that is high enough you can go to sleep at night.

Even when you are working on your credit card debt, pay yourself first. Continue to put as close to 10% of your take home pay into savings as is humanly possible before you spend the first penny on anything else.

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