Step one in any good financial plan is saving a rainy day emergency fund nest-egg. If you want to skip this step, consider this:
– Has your muffler ever dragged behind your car?
– Has your washing machine or refridgerator ever stopped running?
– Have you ever had your credit or debit card declined because your bank account was empty?
These are only three of a million reasons to have an emergency fund. I’m sure you’ll think of more. A savings account is invaluable to stay out of debt, keep goals in focus, and to limit expensive insurance costs. Deciding to build your reserve is simple. But, like most things in life, simple does not always mean easy.
How much should money should I have?
Professionals suggest that a family maintain between three and six months of their living expenses in an emergency fund cash reserve. What exactly are living expenses? For cash reserve needs, living expenses can be defined as those costs you couldn’t live without in times of trouble.
- mortgage or rent payments
- car payments
- utilities like electricity and water
- health insurance premiums
Financial planners refer to these as “non-discretionary expenses.”
Of course, there’s some debate as to what counts as a can’t-live-without-type of expense. For example: could you live without food? No, of course not. Do you have to shop at Whole Foods, or could you shop at a local Kroger and buy generic brands? Surprisingly, each person will have their own response to questions such as these, depending on personal beliefs. Either way, it’s vital to know what you’re aiming for (the goal) before actually taking the shot.
Building a Reserve from the Ground Up
What if you don’t currently have savings that could act as an emergency fund cash reserve? As a first step, stop all of your other savings to establish at least a small reserve of $1,000. Your 401k retirement plan or other long-range strategies are at risk if you don’t have money saved for emergencies.
Why $1000? Most financial emergencies, such as the water heater breaks or a car tire is flat are usually less than $1,000. If you can’t figure out how to reach $1,000 quickly, use your imagination; hold a garage sale or sell under-used DVDs on eBay. Get creative.
How to Maintain Your Reserve
Keep your cash reserve somewhere VERY hard to get to. Set up a bank account at an institution across town – keep it OUT OF REACH!
I can’t tell you how important this is. We’ve counseled so many families in our careers that work hard to create a reserve and then set up the account so that it’s too esy to touch the cookie jar. Leave your hand out.
One more time: NEVER TOUCH YOUR CASH RESERVE UNLESS IT TRULY IS AN EMERGENCY! A quick trip to the beach this weekend because “you work so hard and deserve some time off” is NOT an emergency.
Build the Reserve Toward Your 3 – 6 Month Goal
Systematically add to your reserve every paycheck. Even if you can only afford $25 per week, you’ll be amazed how quickly your funds will add up. It may be an old saying, but out of sight = out of mind. Have funds automatically deducted from your paycheck or bank account. Automatic savings means you won’t have to remember to do it.
Prefer to listen to advice on raising your cash reserve returns? Check out this Two Guys and Your Money episode: #018: Top 5 Ways to Raise Your Emergency Fund Interest Rate. Prefer iTunes? Here’s the link to subscribe.
How Do I Raise the Interest Rate on My Cash Reserve Emergency Fund?
Let’s assume you’ve established your six month reserve of, oh, let’s say, $15,000. You check the interest rate to find that your bank is paying you a whopping 0.01% per year. Low interest rates are great when you’re a borrower, but stink when you’re an up-and-coming saver. What can you do?
In the professional world, we’d help you create what’s called a “Cash Reserve Ladder.”
It works like this:
To find the highest interest rate in a stable investment, you’ll need to lock your money up for a long time. A 3 year CD pays better interest than a 3 month CD.
If your entire cash reserve is invested in a 3-year CD and in the second month you need the money for the flat tire…you guessed it – you’ll pay penalties! Kinda defeats the purpose of an emergency fund.
Instead, here’s what you do:
First, divide the amount of your cash reserve by 4. In our example of $15,000, that would be $3,750. Place one-fourth of your reserve in various-termed CDs or similar GUARANTEED cash products. And no, Mr. Bond Buyer, a High-Yield Junk Bond is not a guaranteed cash product. We’re talking about things guaranteed by the U.S. Government, like bank accounts.
For example, place:
1/4 of your cash reserve ($3,750) in a 3-month CD;
1/4 in a 6-month CD;
1/4 in a 9-month CD;
1/4 in a 12-month CD.
When the one-month CD matures in…you guessed it…one month, buy a 12-month CD with that money. When the 3-month CD matures in 2 months after the first, buy another 12-month CD, etc. What ends up happening is a “rolling” 12-month CD that comes due every 3 months. Meanwhile, as you’re continuing to build your cash reserve, that money is in a local, liquid savings and/or checking account.
You can, of course, build this model out yourself, or you can use our pre-formatted worksheet that takes the guesswork out of it from our two-dollar-or-less toolbox. Click HERE. It’s only $0.97.
In our opinion, especially in light of recent economic issues, a family should strive to have a twelve (12) month cash reserve, not the 3-6 months often preached by financial advisors. We think it’s a ploy to lower reserves so there’s more to invest….which is the portion of your assets they get paid to manage. So, tell your broker no thanks – you’re shooting for 12 months.
Like Us? Sign Up!
Subscribe to get the updates from The Free Financial Advisor.