Financial Planning: Your Emergency Fund

Financial Planning: Your Emergency Fund

Kyle Swaim
TB Group LLC

 

A few weeks ago, I wrote in this space about determining your current life phase as the first step in the financial planning process. Now let’s talk about the second step: establishing an emergency fund.

 

Even the most well-planned life can be disrupted by an unexpected event. Every day, people suffer car breakdowns, get Covid, fall off stepladders, lose jobs… The list of bad things that can happen is endless. Bad things nearly always cost money. And if you don’t have the money on hand to cover the bad thing that happens to you, you may try to skate by with your credit cards or, even worse, take a loan with one of those dodgy outfits that advertises instant cash, no credit check.

 

An Emergency Fund Saves You Money

But credit cards and dodgy loans carry high interest. So if you maintain a healthy emergency fund, and pay cash for your emergencies, you actually live more cheaply.

 

How much do you need in the fund? Emergencies come in all kinds and sizes. The average cost to replace the fuel pump on your car is $1,000 to $1,200. The average cost of a dental crown (according to the users of a website called Realself) is $5,675. The average cost to replace a septic tank and drain field is $6,000.

 

The Origin of the Six Months Rule

One of the worst kinds of emergency, however, is unexpected unemployment. People get laid off, even in good times. There’s unemployment compensation, of course, but that never pays as much as your salary did. According to the Bureau of Labor Statistics, the average duration of unemployment in 2019 (the most recent year for which there are statistics) was 21.6 weeks, which comes out to about five and a half months. That is why so many advisors say your emergency fund should be equal to six months’ living expenses.

 

Where should you keep your emergency fund? Since it’s an emergency fund, you want it to be liquid, so you can withdraw the money in a hurry, if you need to. That excludes most bonds and stock funds. You also want it to be low in risk, partly because it’s important not to lose it, and partly because you don’t want to be preoccupied with tracking it.

 

Try a Savings Account

Fairly liquid and low risk means bank savings account. The FDIC insures bank accounts up to $250,000 per depositor per institution. Traditional banks are fairly notorious for paying low rates on savings accounts, but there are FDIC-insured online accounts that pay respectably. Lots of websites offer lists of these online banks with brief reviews. Just do a web search for “online savings account.”

 

Here’s one of those lists from one of the The Motley Fool websites, and it shows an online account paying 5.22%. A $10,000 account would earn $522 per year. Be sure to review a bank’s policies before opening an account. They each have their own rules for how you put money in and get it out again. For some of them, it takes a couple days to get anything out, and you may find that too inconvenient. Just bear in mind that it’s an emergency fund, and you really shouldn’t be taking money out very often.

 

Once you’re ready for an emergency, you can start the planning part of financial planning. I’ll be writing about that next time.

 

Photo: “Brown and White Bear Plush Toy” by Pixabay via Pexels

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