According to a 2011 survey by the National Foundation for Credit Counseling, 64% of Americans don’t have enough cash on-hand to handle a $1,000 emergency. If you don’t have money put away for emergencies, you’re walking a financial tightrope.
Building an emergency fund is one of the most important ways to protect yourself against financial disaster. It’s an account with money set aside strictly for emergencies and when bad things happen. Experts say when people fail to have an adequate emergency fund in place they often turn to debt.
Because stuff happens
Bad things can and do happen in life. It doesn’t always have to be something totally catastrophic but if you go long enough, some unexpected surprise, incident or problem will leave you with a large bill. If you’re lucky, the problem is relatively straight forward: Your car could break down, the heater in your house could go out, or you might need a new roof.
Then there are the really bad things. You could lose your job and be out of work for two months or you could need an operation and have to cover a $5,000 insurance deductible.
You can’t anticipate when these things can happen but you can prepared for them financially by having money set aside. William Hammer, Jr., CFP, Vice President of Wealth Management for Vanderbilt Partners, said an emergency fund can prevent an emotional struggle from becoming a financial one.
“It’s not that the odds of something terrible happening are that great. It’s that the hardships could be devastating if you don’t have the money. An emergency fund is a piece of mind,” said Hammer.
Aim to have six months living expenses put away
Most financial advisors recommend you have at least six months worth of living expenses or income in your emergency fund. This should be what you need to cover bare essentials such as the mortgage, utilities, food, insurance premiums, childcare costs and everything you need to keep your life running.
You don’t need to include retirement contributions, money for fun on the weekends and other discretionary spending. If your mortgage, utilities, food and all the basics add up to $3,000 per month, you’ll want to aim to have $18,000 in your emergency fund.
Mari Adam, Certified Financial Planner and president of Adam Financial Associates, said while six months is ideal, it can be a little out of reach for most people. She said three might suffice for many and if you can’t meet that, then “something” is always better than nothing.
“Even one month is better than nothing. You need to have something put away to handle emergencies. Some people say they can’t save up six months worth, so they get frustrated and quit,” she said.
Adam recommends putting your emergency fund in an online savings account and setting up automatic transfers to slowly build it to the level you need. You also need to be disciplined and not give into temptation to pull money from your emergency fund to take vacations, indulge in splurges or use it for non-emergency expenses.
If you don’t usually invest in a Roth IRA, Adam said another alternative might be to start building an emergency fund in one. While a Roth is a retirement account, you’re allowed to withdraw contributions at any time for any reason. You can typically put up to $5,000 per year in a Roth and your money can grow tax-free and be withdrawn tax-free in retirement.
“Maybe you put it in a Roth and hopefully you don’t need the money. You’ll have some emergency funds in place and you’ll also be building a retirement fund,” said Adam.
Going without an emergency fund is an open door to debt
When you don’t have an adequate emergency fund, you risk having to turn to debt in a time of crisis.
The N.F.C.C. survey found that 17 percent of respondents said they would borrow money from family to cover the emergency. Another 17 percent said they would neglect existing obligations, 12 percent said they would sell or pawn belongings and 9 percent said they would get a loan from a cash advance store. All of these options can lead to snowballing debt and financial problems.
“Most people will turn to credit cards or a home equity line of credit, if they’re lucky enough to have one when you consider where home prices are at,” said Adam Koos, CFP, President and Founder of Libertas Wealth Management.
The problem with relying on debt is you start accruing interest on whatever problem you had. If you’re tapping a credit card with a 20% interest rate to cover that $1,000 car repair and carry that debt for a year, that problem will now cost you $1,200 instead. Koos said you can “be your own credit card” by saving up the money to begin with.
Adam said whereas many people relied on home equity lines of credit to serve as an emergency fund, fewer people have that option nowadays. Plummeting real estate values across the country means that fewer people have home equity to borrow against.
Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor’s Business Daily. He is the author of “Stuff About Money: No BS Financial Advice for Regular People.“