When beginning the process of financial planning, you may find the first couple of steps to be rather frustrating to complete, requiring heavy doses of time and discipline. Step one is to spend less than you make; you do not want to begin saving towards your goals until you actually have money to save. Step two is to eliminate all consumer debt; you do not want to begin investing only to have your gains offset by high interest rates on debt. Once you have these two steps out of the way, you will feel that you are ready to lay out your financial goals, make investments, and start watching your money grow into a down-payment on a new house, a retirement fund, or college tuition for your son or daughter. Unfortunately, if you proceed in this fashion, you will have missed the all important but often overlooked third step of the financial planning process.
Step three may be a difficult step as it will adversely affect how much you will be able to initially contribute toward your financial goals. Worse yet, although step three should be mandatory, most people do not know of it or do not understand it, and end up skipping it altogether. The truth is step three involves making a financial investment, one that you should make before making any other investments for any other goals. And, although it initially delays investing for your future goals, it may end up being the most powerful financial investment you ever make. So what is step three? Step three is to establish an emergency fund.
An emergency fund is just as it sounds—a sum of money that is to be used in the case of an emergency. From a financial planning aspect, an emergency is the sudden need for unforeseen mandatory expenses. As much as you may think an emergency will not happen or that you can make do without a plan, remind yourself of these keywords: unforeseen and mandatory. Potential emergencies include: a leaking roof, a last minute plane ticket, a crashed car, a broken leg, a flood or hurricane, or even a terrorist attack. The last thing you want when you need money in an emergency is to be forced into selling securities when the market is down, paying penalties to liquidate investment accounts, or incurring capital gains at the wrong time. An emergency fund is powerful because it allows you to handle unexpected financial needs without disrupting your investments that are working toward your goals.
Getting Started
Having an emergency fund can be simple and painless. By adhering to a few easy-to-follow guidelines, you will be well on your way to better protecting yourself and your financial situation. So, when establishing your emergency fund, remember the following three rules (in order of priority):
- Be able to get the money quickly.
- Keep it separate from all other money and investments.
- Put it in an account that conservatively earns interest.
Where to Put It
Perhaps the easiest place to establish your emergency fund is in your primary checking or savings account. We strongly suggest otherwise. Despite allowing for quick access to your money, you want your emergency fund to be in its own account, separate from the money used for other expenditures. Doing so enables you to quickly determine the value of your fund, and can help deter you from inadvertently using the money for something other than an emergency.
An ideal place to hold your emergency fund is in a money market fund account. Money market funds are actually investments in short-term debt, but the investments are usually considered almost free of risk. The rate of return on a money market fund will fluctuate in accordance with interest rates, so you can expect it to offset some inflation. Additionally, although your money is technically invested, money market fund accounts usually permit immediate access much like a standard checking account would provide. Nonetheless, despite the advantages to these accounts, one potential drawback is the initial investment requirement. Many money market fund accounts require a certain minimum initial investment in order to buy into the fund. However, if you are unable to meet the minimum of a particular money market fund, you should simply extend your search, looking for offerings at other banks, credit unions, investment firms and other institutions.
Another viable option for an emergency fund account is an online high-yield savings account. These accounts are becoming popular because, by being exclusively online and demanding low-maintenance clients, the banks providing these accounts are able to offer rates of return that are typically higher than money market funds. Furthermore, these accounts are FDIC insured just like normal bank accounts and may require almost no minimum initial investment. However, the added advantages come at the cost of quick access to your funds. Rather than having an ATM card or a checkbook, you may only be able to access your money by way of initiating transfers to and from accounts at other banks. Although they may be convenient and free to make, these transfers will likely take several days to complete. Should you choose to hold your emergency fund in an online high-yield savings account, you will want to plan for provisions, such as having additional cash available in your primary spending account, in the case that you need an immediate surplus of funds.
It is important to note that when selecting where to put your emergency fund, the rate of return is very much secondary to just having the fund in its own account and having quick access to it. If you do not feel comfortable moving your money to a new bank or money market fund account, or feel that you will not be gaining an advantage by doing so, then use a standard checking or savings account with the bank that you know and trust (even if it does not pay a high interest rate).
How to Build It
Ideally, your emergency fund should have at least three months of living expenses in it. A more conservative six months of living expenses is preferred by many. But, if you do not have enough money to make a full initial deposit into the account, then build your emergency fund just like any other investment account: make an initial deposit and gradually add to it on a frequent and consistent basis until you reach the proper level. Of course whenever you make a withdrawal from the account, make sure that you begin building the fund back up as soon as possible.
Summary
An emergency fund should be a part of any sound financial plan. Once you start investing toward your financial goals, you do not want to disrupt everything in order to cover an unforeseen but mandatory expense. Money market fund accounts and online high-yield savings accounts provide a means to hold your emergency fund while also earning some interest to help counter inflation. Your emergency fund should contain three to six months of living expenses. Most importantly, be sure that your emergency fund remains a priority above your other investment accounts. Whether it is the first investment account you ever open or a long overdue addition to your established investing strategy, having an emergency fund account is a smart decision. Once you have established your emergency fund, you can confidently proceed with the more exciting aspects of financial planning—defining and working towards your financial goals.
Written by CitrinGroup Staff 03/02/06 |
