Financial Planning 101: Emergency Reserves

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In case you missed the last several weeks, we are in the midst of a weekly Financial Planning 101 crash course on the blog.  For a list of all the topics to be covered, see the course syllabus intro post.  Today’s topic will be a relatively straightforward one: Emergency Reserves.

Most people understand that they should have some money set aside for emergencies.  Tree falls on the house.  Medical expenses.  Car repairs.  A rainy day fund.

This is essentially an extension of the insurance planning topic we covered a couple of weeks ago.  The emergency reserve is your mini self-insurance policy.  It is there to cover the risks that won’t devastate you financially, but may cost you some money here and there.

If your washing machine breaks and needs to be repaired or replaced.  If you blow out a tire on your car and need to get a new one.  You drop your cell phone in the toilet.  You have to fly across the country for a funeral.  Your four-year old son wants to see if he can fly, so he jumps out of a tree and breaks his arm and you have a medical insurance deductible to pay for.  Your daughter, who just got her driver’s license, backs your car out of the garage…but forgot to open the garage first.

$#!✝ happens from time to time that costs you money, but doesn’t necessarily ruin you financially.  Rather than buying insurance for all of those little things, have a sufficient emergency fund to cover those occasional events in life that unexpectedly occur and cost you a few dollars.

How Much Should I Have?

What I typically like to see for an emergency fund is an amount equal to three to six months of fixed expenses.  Fixed expenses are your regular bills and expenses that are mandatory.  Housing payment, student loan payment, car payment, cell phone, electricity, gas, water, and a minimal amount for food.  You can survive on Top Ramen and spaghetti – we’re not buying Copper River salmon or eating at Morton’s Steakhouse if we’re in a bind.

Basically, however much you need to be miserable in a month, multiply that by three and that is how much you should have saved at a minimum for emergencies.

So, if you need a minimum of $4,000 to cover your basic bills and expenses in a given month, you should aim to have between $12,000-24,000 set aside in an emergency fund.

Now, there are exceptions to this.  For example, if you are carrying a balance on a high interest rate credit card, I would like to see you pay off that credit card balance before building up a sufficient emergency reserve account.  There is no sense accruing 18% (or more) in interest on a credit card if you have cash on hand.  We covered debt in last week’s post, so once your debts are under control, aim to build up a sufficient emergency fund.

Where Should I Keep This Money?

This is money you have on hand for emergencies.  You might be thinking you should keep it under your mattress, in a hole in the wall behind a picture frame, or possibly buried in a coffee can in the backyard.  Those are all perfectly suitable options.  However, given we have a pretty strong banking system and most payments are made electronically these days, you don’t need to hold it all in cash.  I have several rules for where to keep your money for emergencies:

  1. Safe
  2. Liquid
  3. Free / No catches

Keeping it safe means it needs to be someplace where it won’t go down in value and it is protected from outside variables.  No stock market, or investment of any kind.  I recommend using an FDIC insured bank account.  Being FDIC insured means it is a real bank, insured by the US government (up to $250,000).  No burglars can steal it.  If your house burns down it is still safe.  On the slim chance the bank goes out of business, the balance is insured by the government.

Being liquid means you can access the money whenever you need it, within a couple of days.  Unless you are into some shady operations, you should never need access to that much cash instantly.  Just don’t keep it in something that is locked up for an extended period of time.

Lastly, I don’t want there to be any fees associated with where you hold the money and no catches.  You shouldn’t have to jump through any hoops if you need to get to it.

Taking it one step further, I recommend using a high-interest savings account.  “High interest” is a little misleading.  You are looking at 1.5-2% on the high end as of August 2018.  But 2% is 2% more than you would be getting on the money under your mattress, so it is better than nothing.

The point isn’t to grow this money into a substantial sum.  The goal is to have it try to keep pace with inflation.  Things get more expensive over time, due to inflation.  If our emergency money is just sitting there (hopefully never being utilized for emergencies), it can grow a little bit over time to keep up with cost of living increases.

Where Do I Find High Interest Savings Accounts?

Online banks are your easiest option.  Some credit unions offer competitive interest rates, but those are only offered locally.  You can simply Google, “high interest savings” and find plenty of options.  You can also compare options at https://www.bankrate.com/banking/savings/rates/.

Just make sure there are no minimum balances (or a very small one), no fees, and you can transfer the money to your regular checking account within several days if need be.

Conclusion

Pretty straightforward.  Three to six months of fixed expenses, held in a high interest savings account.  Link the high interest savings account to you regular checking account so you can transfer money back and forth as needed.  Hopefully you never need to dip into it for emergencies, but you will be glad you have it if and when an emergency pops up.

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