In the January 31st blog post, I outlined what comprises a basic financial plan. Let’s start now with the first item – an emergency reserve (or what I call in the plan “Cash”).
The first goal for your financial plan is establishing an emergency fund roughly equal to 3-6 months of your living expenses. Many experts, such as Dave Ramsey in his bestselling book “Total Money Makeover”, say to initially shoot for $1000 and then build from there to the 3-6 month amount. Why 3-6 months? According to data from the US Department of Labor (DOL), the average time it takes to find a job is 3 to 6 months, depending on a variety of factors such as where you live, your education level, the level of position you are seeking, and others. For many people (almost a third, according to the DOL) it can take more than a year.
A long-time friend, who is also a client, is going through a situation that demonstrates the importance of why you need an emergency fund better than any example I could invent. My friend and about a dozen co-workers were recently downsized at their firm. They were all promised severance packages that contained both pay and medical benefits for a period of time based on the number of years they had been at the company. Then, just before the benefits were to kick in, the company announced that they were under government orders preventing them from paying any severance. This means, for now at least, my friend and the rest of the group are scrambling to figure out how to cover their expenses.
Fortunately, my friend has some savings to use for a while and, in a “worst case scenario”, has reached the age where retirement savings can be accessed without a penalty. But ask yourself this: what would you do if your paycheck went away tomorrow? How long could you get by?
This is why having 3-6 months of your living expenses in cash is so important. First, spend a little time figuring out what a month’s worth of your expenses looks like. I know a lot of you don’t like using the word “budget”, but it is important to undertand at least the mandatory items you have to pay for – food, shelter, heat, transportation, etc. Some of the “nice to have” items can be eliminated in an emergency, but if you can’t live without things like TV, internet (gasp – did he just say I might have to live without internet?), the latest electronic gizmo, etc., then you will need to include those items in what it cost you to live for a month. Be honest. Include all of your expenses on the list and then figure out which ones are the “absolutely can’t do without” items. The total of these payments times at least 3 should be the minimum target for you.
This money should be somewhere safe – like a bank account. It isn’t as important that it earns a lot of interest as that it is available in an emergency. If you can’t resist the temptation to use this money for something other than an emergency, you should make it a little less convenient to get to – for example, a savings account that isn’t linked to your debit card or checking account and isn’t accessible on-line. This makes you actually go into the bank to get it; hopefully giving you time to remember that it’s for emergencies!
Next time we’ll talk more about an emergency savings and about some ways to start saving for this emergency fund. Until then, feel free to email us with comments or thoughts for future articles. You can reach us at [email protected].