Emergency Plan: Better Than an Emergency Fund
By Flexo 29 comments
Last year with the world economy in turmoil, Suze Orman, arguably one of the most vocal personal finance gurus, revised her emergency fund philosophy. Suze began advising her readers and listeners to put aside accelerated debt repayment in favor of building "as much of an emergency fund as you can...even if it means curtailing your credit card repayment strategy."
With job losses in the news, the prevailing rule of thumb came to rest on a larger-than-life bank account set aside only for emergencies. Some personal finance experts began calling for Emergency Funds holding six to twelve months' worth of household expenses while others wanted to link the size of the bank account to the unemployment rate. For every percentage point of unemployment, safe savers would have one months' worth of expenses set aside in a high-yield savings account.
According to the Bureau of Labor Statistics, the average family spent over $4,000 a month in 2008. Even if we assume only $2,500 of that represented necessary expenses, a 10% unemployment rate would result in an emergency fund totaling $25,000. That's too much cash to have sitting around earning ridiculously low interest. You lose purchasing power because your after-tax returns on cash, even in high-yield savings accounts, are not going to beat inflation.
I suggest a tiered approach to let your Emergency Fund work a little harder for you while still ensuring you're covered in an emergency. This is broader than just an Emergency Fund; it's an Emergency Plan.
1. Store cash somewhere safe in your house
Before I'm accused of being paranoid, having perhaps one hundred dollars hidden in a place a burglar wouldn't look will help you get to a cash machine or a bank in an emergency situation. As I mentioned, you want your money to work for you, so you don't want to leave more than a small amount in First Bank of Mattress.
2. Open a high-yield savings account
These days, the term "high-yield" is more of a joke than anything else. Yes, by opening an account in one of these online savings accounts, you will be earning more than you would in traditional savings accounts offered in bank branches, but it's not much. To choose the right bank, weigh the interest rate against how fast you can get the money in your hands. Consider keeping three to six months' worth of expenses between cash in your house and in the bank.
3. Invest the rest
Temporary emergencies like the loss of a job are, in normal times, resolved within six months. Chances are good you won't need to touch your investment. But if you deplete your savings and need to come up with more cash, start with your Roth IRA. Your contributions can be withdrawn at any time tax-free and penalty-free, and if your situation is resolved, you can re-contribute your withdrawn funds. Without a Roth IRA, you would have to sell taxable investments. This is not a preferred option, but that is why I suggest having a six-month buffer in cash.
Editor's Note: A commenter below mentioned that there are certain requirements you have to meet in order to withdraw assets penalty-free.
4. Access your credit
Always keep an unused credit card at the ready. I am not opposed to recommending the use of credit cards in emergency situations to people who have shown responsibility with their finances. Going into debt is not ideal, so avoid it if possible. The best scenario would be to use a credit card only when you know your emergency situation will be resolved before your bill is due.
Don't take a loan from your 401(k). Doing so would expose you to significant risk. For example, if the economy is not doing well and you find yourself struggling, chances are your employer is struggling as well. You don't want to take a loan from your 401(k) and find yourself out of a job — your loan will become due immediately.
If you own a home, you have access to what might be "slightly better" than credit cards, a home equity line of credit. Rates are often lower but there is a danger of losing sight of your debt. Debt in any form should not be your only emergency plan.
5. Ask for help from family and friends
No one likes to admit they need help. If you're generally well-prepared, emergencies shouldn't come along too often. As long as you are in a true emergency, are seen as trustworthy, and don't have a history of asking for financial favors, your family and friends might help if they are in a position to do so. I've found the more compassionate you are, the more likely the people in your life will be compassionate towards you. But just like credit, asking for favors should be a last resort.
6. Reduce your expenses
I'm including this at the bottom of the list because it isn't technically a way to access money, but this should probably be the first thing you think of in a emergency situation — once you are clear of any immediate danger. Reducing your expenses will make tiers one through five last longer or go farther. Consider making sacrifices you wouldn't ordinarily make and taking a few more steps towards frugality.
What is your Emergency Plan? What do you do beyond keeping cash in a savings account to prepare for when you won't be able to use your income to pay your expenses?
This is a guest article by Flexo of Consumerism Commentary, a founding member of the Money Tips Network. Flexo is starting the second week of his ten-day, ten-venue tour. If you enjoyed this article, please subscribe to his RSS feed, follow him on Twitter, or check out some of his best articles:
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"I'm including this at the bottom of the list because it isn't technically a way to access money, but this should probably be the first thing you think of in a emergency situation — once you are clear of any immediate danger."
I disagree with (a part of) the statement you made in #6. The purpose of your article is to discuss an Emergency Plan. Whether #6 (reduce your expenses) is a way to access money is irrelevant. An Emergency Plan should be how to access money as well as options to reduce your expenses.
I agree with the rest of your statement though. Reducing your expenses should be one of the first things you think of when an emergency arises.
In fact, if an emergency arises for me, I look to fund it... but PRIMARILY, I look for a way to reduce my other expenses to compensate.
Last November when my employer began quietly laying people off, my husband and I made a plan in case that happened to me. At the time it was an exercise to calm my nerves, but 3 months later when I was in fact laid off, we went immediately to The Plan. Having it helped us through the paralyzing fear that accompanies such dramatic changes in circumstances. We'd already done the work of rationalizing the worst case scenario (foreclosure, moving in with his parents) and were able to move forward. Because we were able to act quickly, everything has worked out very well.
The Plan doesn't have to be fancy. When crisis comes, any plan at all is helpful. Plus, if you've already reconciled yourself to living in someone's living room, anything better that comes along seems great.
@Q: Making a plan ahead of time so you're ready to enact it is the key to keeping your sanity during a tough time. I'm glad that worked out for you.
Plan to save weekly - a simple savings account, even $25 per week over 2-3 years adds up, never touch a 401 K and don't touch an IRA unless your most valuable asset depends on it. Don't get debt that you don't need, simple but it works. Credit Card not cards - 1 with a limit of no more than $1000 to be used in a crisis, don't use one from your bank, get one on-line with a high risk lender, they are used to waiting on their money, pay the minimum at best until the crisis is over then hurriedly pay it down to avoid the crazy interest. Don't store anything of value in your house, it will get lost or stolen - find a credit union (CU) with a solid reputation and use a safe deposit box for valuables and cash, keep your itemized record of the account handy and forget banks at this time, they are all about the bottom line and profit. CUs attempt to build a relationship with you and you can build one with them, at your worst offset, if your rep with them is solid to excellent, they will give you money and help you tackle your finances until you're back on track.
@Stewardship: Great tips, thanks!
I'd like to add a point to #3 on your list. I would hope that you would advocate that the Roth IRA be invested very conservatively, either in government bonds or very high quality corporate paper. Otherwise, someone could lose their job and have to withdraw savings at a time when the stock market is down.
Other than that, great concept though. I also think having too much money in cash is a personal finance sin.
To add to #1 keeping cash on hand, it makes sense to keep smaller bills handy. If suddenly you find yourself evacuating (like after Katrina) you may be dealing with people who don't have cash to break a $100 bill or even a $20.
Flexo, great post! I think that you definitely made a strong argument for not leaving all your money in a single savings account earning next to zero interest.
One other point that I think is important that part of the plan should be a discussion with your family. As stated in a previous comment decreasing spending during an emergency is a great way to make an emergency fund last longer. It is important to discuss with your family which expenses are discretionary, and what can get cut first if necessary.
First bank of mattress?
I love it, absolutely love it.
These are all great ideas--just make sure the cash is well hidden, nobody knows about it, and it truly is a small amount
Usually we take our tax return and either wipe out or significantly reduce our credit card debt. Sadly, even though we get a significant return, it would only make a small dent in our current debt. We've also cancelled two cards recently to avoid getting hit with (more) outrageous APRs, which leaves us with the reality that we may end up having to do the same with the other two. Yes, not fun admitting to the number of cards and amount of debt we've accumulated, but there you go. So we've decided to take this year's return and use it for an emergency fund/living expenses and using the income we would normally use for living expenses to beat down the cc debt. And, if we do end up with little or no available credit, we have something to fall back on in an emergency. We've sat down and developed a debt repayment plan to go along with this and have also discussed options if we were to lose our current income. Wish us luck!
This First Bank of Mattress helps me a lot some time. I have nothing to buy for my meal one day, I don't have someone to ask for money. Then I've remembered I do have this First Bank of Mattress.
Thanks for the tips Flexo! Thoughtful post. :)
Mattress/favorite book/under the rug stash comes in handy also if snow has hit & kids are going around shoveling snow for 5 or 10 bucks. Then just note to yourself to put the money back next pay day with $5 interest.
This is a great post! Thanks for organizing this way of thinking beyond the emergency fund. I'll definitely be talking this over with my husband at our next family finance meeting.
Sierra Black - embracing the wild heart of parenting at www.childwild.com
This is a great post! Having an emergency plan is indeed a lot more important than having the correct amount of cash stashed away for emergencies. An emergency plan can take individual situations into account much better than just one number that determines the "correct" amount of emergency cash.
Wow, this is really similar to the plan I have in place and wrote about a while back in my Livejournal journal. Great minds do indeed think alike! First time I've seen a problogger talk about this approach, I think.
Great post, I tend to keep most of my money in the stock market.
But one thing I think is pretty important is to have a couple sources of income outside of your job.
This way if you get fired and need $2,500 a month to live off of, but you make $1,000 a month from other sources it is going to really lower the amount you need to have in an emergency fund to survive.
Very true that you should have multiple sources of income, also keep in mind that if you need COBRA you may need to increase your expenses at a time you have the least ability it afford it.
This is a really good article, but not really what I was expecting by the title. I think another aspect of an emergency plan should be how to make money.
I think it's good to plan some ways, besides just having a savings account and lowering you expenses, to really get through an emergency. Things like tutoring, taking a "crappy" job, freelancing, etc.
@Staci great idea to keep smaller bills on hand instead of larger ones.
One idea for safely storing money at home is to cut a small slit in a tennis ball and fold some cash into it. Keep it with other tennis balls and sports gear and you're set.
Just remember which one to grab if you have to leave quickly!
I wouldn't blindly ask family for help. You'll be suprised at the emotional strings attached unless you are very lucky. That may be a little cynical but it is my experience. The trick is never to be indebted to someone, and should only be the last resort.
Hello,
I really enjoy reading you blog, but I did notice an error in your article. In this section:
3. Invest the rest
Temporary emergencies like the loss of a job are, in normal times, resolved within six months. Chances are good you won't need to touch your investment. But if you deplete your savings and need to come up with more cash, start with your Roth IRA. Your contributions can be withdrawn at any time tax-free and penalty-free, and if your situation is resolved, you can re-contribute your withdrawn funds. Without a Roth IRA, you would have to sell taxable investments. This is not a preferred option, but that is why I suggest having a six-month buffer in cash.
You mentioned that you can withdraw assets from a Roth at any time tax- and penalty-free. I actually work for an investment firm and my group specializes in retirement account marketing. We've worked on a lot of Roth IRA pieces, and this topic of when you can withdraw assets is a very confusing one that many people get wrong. While you're correct in saying that you can withdraw assets tax free, unfortunately the penalty part of that statement is incorrect. There are certain requirements you have to meet in order to withdraw assets penalty-free (one being holding the Roth IRA for at least 5 years). Publication 590 on irs.gov outlines these requirements.
Your emergency plan needs to include a plan to maintain health insurance. Are you eligible for COBRA? How much will that cost? (Hint: more than you're currently paying for employer health insurance.) Are you, or your children, eligible for state health programs like medicaid or CHIP? Do you qualify for one of the new high-risk pools? What would the premiums be? Is there a place in your community to get low-cost healthcare and vaccines for the kids? Look into these resources *before* a job loss, so you know what to do in an emergency.
A huge # of bankruptcies are caused by illness that prevents the person from working at the same time as they get socked with 6-figure medical bills. So knowing your health insurance options, as well as having disability insurance, are essential parts of your emergency plan.
The idea of having an emergency plan is a smart one to just having an emergency fund. Thanks for this great post.
I was expecting an actual plan, not a way to invest your hug efund. A plan to me would be In Case of Medical Emergency Steps 1-5, In Case of Unemployment Steps 1-5, etc. a set of plans for various cases could be much more useful than just having a bunch of money available in different vehicles.
My husband and I have recently been faced with closing our credit card accounts and going to a cash basis. We do have debit cards but find it easier to budget and work with cash only. In addition to a small amount of money hidden at the house we also each carry $40 emergency cash hidden in our wallets. This helps with buying gas or groceries when something unexpected comes up. Each week when we get our cash for groceries and our allowance we replenish that first if needed, then use the balance of the remaining money to purchase what we need.
It works for us.
We have an emergency plan in place, but it goes beyond just money and how to respond to a job loss. There are many places you can access cash, including HELOC, Roth's, either 401k or IRA, with 5 yr investment and reselling stuff. However, I think any plan should include figuring out how to feed yourself or your family in the event of any emergency. I've been watching the events in Egypt and that is the classic example of when you need to have a plan, put it into action quickly, and that plan might include evacuation, too. Fortunately, US is somewhat stable politically, but I'm sure the Egyptians thought the same thing before the rioting began, given that Mubarak was there for 30 years.
We have a financial emergency plan- a Plan B budget, based on my possible loss of job (hubby has a 3 year contract). We have exactly enough to last 6 months, so the plan is to move within 2 months if necessary, so we do not deplete our savings.
We also have a "real" emergency plan- it involves 4 money belts- one for each member of the family- complete with some 20 dollar bills, and xeroxes of things like birth certificate, license, and passport. Why? In a real emergency, like fire or flood, trying to prove who you are to have access to your money, or records, can be extremely arduous, and waste weeks.
We are currently working on a "bug out" plan- in case of societal distress. Far less likely, but I've always planned to retire to a home in the woods anyway!
I think you should re-name this article "Your Finances: A Better Life Plan"
All of these points are simply good financial habits. If people lived this way normally they wouldn't have to worry (as much) about losing a job or dealing with some other financial emergency. They would be prepared from the get-go, instead of struggling to get by.
How does one calculate what amount is “too much cash to have sitting around earning ridiculously low interest”? If the average family spent over $4,000 a month and $2,500 of it was necessary expenses – as laid out in this article – wouldn’t they still need to put away $24,000 to $15,000 for their 6 month emergency fund? The family – if they wanted to be on the safe side – might lean towards the upper end to have stashed away. But what’s the tipping amount (and how do you figure that out) on the spectrum of $24,000 and $15,000 in which the emergency fund was too much?