The Importance of Creating an Emergency Fund

January 15, 2011

An excerpt from Follow the Money Weekly Radio with Jerry Robinson

by John Bearss

TranscriptLast week we talked about life-triggering events that could create a need for financial advice and we also talked about the importance of establishing a budget.
Today we are going to talk about creating an emergency fund. You have heard Jerry talk about the difference between savings and investments quite a bit, and I believe as he does that creating a savings or as I like to call it, an emergency fund, is one of the first things that people need to do immediately to help them build a successful financial plan.
An emergency fund is a pool of funds that you hold in a readily available form to meet unexpected needs. For example, what if you had a sudden loss of income? Or what if you had an accident and needed funds to get your automobile repaired so that you could continue to get to work? I would consider these emergencies. On the other hand, purchasing an expensive item that suddenly goes on sale or buying stock when its price suddenly drops, is not an emergency fund. You need to understand the difference between “need” and “want” when developing your concept of what these funds are for.

Emergency funds are not to be used for meeting anticipated expenses like paying your real estate taxes, your gas and electric bill or a student loan or tuition or even taking a vacation. Instead, an emergency fund should be viewed as a fund that will protect you, your family, and your loved ones against unexpected financial crises.

So how much money should you keep in an emergency fund? I have noticed that over the last two weeks that there have been many stories in the mainstream media about this very question. The general rule of thumb that they have come up with is three to six months of routine living expenses. I believe that it should be higher. I think that it should be 6 to 12 months of routine living expenses. However, the amount of your emergency fund should be based on your own personal situation. While basic guidelines do exist, you should adjust them to reflect your unique circumstances. Some factors you should consider when determining an emergency fund goal include job security, the condition of your real estate, and the health of you and your dependents. You also may want to consider items like how much is your car insurance deductible if you had an automobile accident, what is the deductible on your homeowners insurance if something happened to your home or what is your out of pocket cost if you had to go to the hospital? Naturally, such factors change with time, so an annual review and adjustments are important elements of the planning process.

I have heard many people tell me that their credit card is their emergency fund. I would highly resist that urge because you will have to pay that back at interest rates that are too high. Personally, I would rather pay myself back with interest.

So, what are some sources you may want to consider when developing a diversified strategy for your emergency funds? Laddering your funds is a concept that I believe you should consider. For example, you may want to hold enough cash to take care of one month living expenses somewhere where you can get it without having to go somewhere to get it. The second through fourth months of living expenses you may want to consider putting into a bank account like a savings account, a money market account, or a CD. Some place where it is federally insured. Then your reserves that you will need for months five through 12 should be put in places like purchasing gold or silver or a life insurance policy which builds cash value quickly. By using this laddering idea not only have you diversified your emergency fund between different places, but you also have diversified between different types of financial products.

So, where are you currently when it comes to having an emergency fund? Are you missing the goal? If so, by how much? I believe that after establishing your budget, establishing an emergency fund is the next important item to attend to.

I trust this financial insight has been helpful and I look forward to the next time when I can help you provide the foundation for a lifetime of financial independence.

RELATED: VIDEO: How To Reduce Income Tax On Social Security Benefits

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