The memory of the 2008 US recession is still fresh from the memory of people especially for those without an emergency fund. It affected everyone’s life and forced us to take a long hard look at our personal financial health. It made us look deep in our accounts and our pockets to check if we have enough to tide us through tough financial times.
This is where an emergency fund plays a vital role in the lives of consumers. Some people think that they can use their retirement fund in cases of emergencies and to some extent, they are correct. But there are conditions before using the retirement fund for emergencies. But this should always be the exception rather than the rule.
Most of our funds are clearly labeled to distinguish the specific functions of each in our lives. Savings is meant to be our savings account, retirement funds should only be used for retirement and emergency funds are for those unforeseen circumstances life throws our way. Forbes.com recently shared the news that more and more Americans are using their retirement fund as emergency fund. Proof of this is about $5.7 billion in penalties.
The 401(k) carries a 10% penalty for early withdrawal. From what the Internal Revenue Service (IRS) collected in penalties, that is about $57 billion in retirement fund taken out too early to cover emergencies. That money will no longer earn interest for the retirement of those that took it out.
Emergency fund characteristics
The emergency fund we are building up is meant to do a lot of things. Primarily though is it should be able to financially secure us in the face of job loss. If you have a business of your own, then it should be able to replace what you earn from the business monthly. Bottom line is that the emergency fund should be able to cover the income that is coming into the household to cover the expenses for a few months.
There are different schools of thought on just how much emergency fund you need. Dave Ramsey is promoting $1,000 as a first step in creating a full emergency fund, Suze Orman recommends 8 months worth of funds for life emergencies and other experts has their own opinions on the matter. The good thing about it is that they all have a common denominator – the emergency fund should cover expenses anywhere between 3 months to 12 months
Greatfallstribune.com share the ideal characteristics of an emergency fund in a recent post. This can help individuals who are just starting to put together the fund and even those that are well into their way of completing a target. This can serve as a benchmark with which to measure the fund against.
- Liquid. The emergency should be easily flexible in nature. Flexible in terms of being able to transfer the funds into dollars anytime, if they are not in dollars. You should be able to send those out quickly as payments when you need to in order to cover expenses.
- Accessible. The fund has to be easily accessible and you can get your hands on it any day of the week and anytime of the day. Emergency situations does not wait until the bank opens so it needs to be “in arm’s length” so to speak. Do not tie it up in accounts that takes days to process.
- Capital. Emergency funds is meant to get you through emergency situations. You are not building the fund to be used for aggressive investments hoping it yields more income. There is nothing wrong with investments but keep the emergency fund away from possible losses because you would need the capital intact when emergency strikes.
There article also shared some insights on how to start putting up an emergency fund.
- Emergency scenario. It starts off by listing down and studying emergency situations that might take place in your life. Rule of thumb is to list down worst cases to have an idea on the maximum income replacement you would need to make your emergency fund work.
- Budget. The next thing to do is to scrutinize your budget. Check how much income is coming in, how much expenses are coming out, and what expenses are non-essential. You would need to know and prioritize the expenses when emergency strikes.
- Decision. At this point, you should be able to figure out the amount you need for a monthly emergency fund. It is now time to decide how many months you need. It is a balance of how much you can put in to meet a target and how much you realistically need. Do not stress yourself in meeting a 12 month target if 8 months worth of emergency fund will do.
Student loans and emergency fund
For some, there are a few steps to survive without an emergency fund. But for most, an emergency fund could be the only thing separating them from getting in a mountain of debt. Borrowing and not being able to pay back is a vicious cycle. You borrow, and when the bill comes in you borrow again to pay for it and borrow again to pay for the second and so one. Once you miss a payment, interests and penalties start to come in.
Huffingtonpost.com recently shared a story on how an MB graduate saw the value of an emergency fund and took on the challenge of having no job after graduation, no income and a big student loan debt.
- Get a job. The graduation high wears off after a few days when you realize that you have no job, no income, no savings, no bank funds and a huge student loan debt. This changes your lifestyle overnight. Frugal living quickly enters your mind and looking to save up money you don’t have is on top of the list. Getting a job should be priority number one because this is where you will get the funds to pay off bills buy food.
- Budget. Knowing how much you need to pay for living expenses and to pay off debt is important. This allows you to manage your income wisely and gives you the framework to check expenses before they incur. It helps you stay on track and set your sights on the goal.
- Emergency fund. After college, a graduate will have no income most will be in debt. This is a feeling you can’t shrug off instantly. It hounds you and follows you wherever you go. It restricts your lifestyle and every purchase. Putting up an emergency fund as soon as you start getting a salary can prevent that scenario from playing out again
- Auto-debit. Interests and penalties on payables usually kick in when you delay on your payments. One idea is to use the auto debit function of your account to pay for the bills. This way, the only thing you have to remember is to ensure the funds are available for payment. Some lenders even provide interest discount for those enrolled in auto debit. Talk to your lender about it. It can save you hundreds of dollars down the line.
- Negotiate. Interest payments is a necessary burden to get the loans in the first place. Talk to your credit lenders and see if you can get a lower rate. Of course, you need to have a good credit standing to show that you are not a big risk and you put importance in on-time payments.
- Enjoy life. Engagement parties, weddings and holidays occur too far in between the lives of people. Being in debt can restrict some expenses but you can be creative is looking for ways to attend these life events with least amount of funds possible. Try taking a bus to get home for the holidays or pool-up money with other friends to buy a gift for your friend’s wedding. Save up in advance so you can fly out to a relatives house for a special occasion. Having debt is restrictive but it shouldn’t stop us from living life.
Building an emergency fund is a great help in ensuring that we are covered in case of life emergencies. It is our safety net for a few months which should be enough time to get back up and start earning again.