(Photo: Forbes UK)
cash. I never get the chance the ask him for his reason but one thing is for sure, if an unexpected situation come their way(like fire), all their money would be swiped out in a flick of a finger.
The good thing about it, they were able to prepare for the rainy days. The not-so-good thing was, maybe they are not aware where to keep their money safely aside from under the mattress.
This article was originally published on Yahoo! and it could open your eyes on where you can best invest your money.
Are you trying to decide if you need an emergency fund? Do you already know that you need one and are just looking for a way to start saving?
Perhaps you want an emergency fund with a little extra yield. If any of
these scenarios sound like you, keep reading because there's little bit
of something here for everyone.
If You Don't Have an Emergency Fund
Unfortunately,
many people may find themselves unprepared for even a modest expense
when it arises. If you're a glass-half-full kind of person, it's
important to realize that luck and chance happen to us all. Having to
buy a new tire for the car, fixing the home air conditioner or covering
your annual deductible can be a nuisance, let's be honest. In this day
and age, though, that isn't the worst thing that could happen. Many
people in the past 15 years have suffered through layoffs, restructuring
and downsizing. Some of you may have been in poor health or had to take
time off from work to help a sick family member.
With that in
mind, how much should you really have saved if you want to cover
something a little more dire than the washing machine going out on?
First, let's look at the general guidelines provided by most financial
advisers and then compare those guidelines to real life by looking at
some numbers provided by the federal Bureau of Labor and Statistics.
Years
ago, when I was studying to become a Certified Financial Planner, the
general rule of thumb for emergency savings was multi-tiered and went
something like this. If you are a dual-income household you would want
to save enough to cover three months' worth of expenses, and if you are a
single-income household you need to be able to cover six months' worth
of expenses.
On the surface,
this sort of makes sense and at the very least gives you a reasonable
benchmark to shoot for. However, it's important to realize that these
guidelines were developed within a framework that assumed that the
client was financially responsible within all areas of their lives (i.e.
they didn't carry massive amounts of credit card debt, had a reasonable car payment, and didn't buy more house than they could reasonably afford).
On top of that, the information used to develop these guidelines was
mostly based on employment data from the '80s and '90s. The problem with
this is that since the end of the '90s, we've had a tech bubble, a
housing bubble, a freeze in the credit markets and an energy bubble, all
contributing to longer periods of unemployment for large swaths of the
population.
How
long are we talking here? Well, despite unemployment being in the low
5% range for the past four months, according to the Bureau of Labor and
Statistics, the data also indicates that the average length of
unemployment has been between 26 and 31 weeks (6–7.5 months) with the
median between nine to 12 weeks (2.5–3 months). So what does this mean
for you? It means that if you were to save three months of living
expenses and lose your job, then you'd better hope that you fall into
the median and not the average. While any amount of money set aside for
emergencies is better than nothing, the most current data from the BLS
indicates that your target for savings should be more in the 6-9 month
timeframe. Now logic tells us that this is probably enough, but I'm a
firm believer in Murphy's Law, which states that anything bad that can
happen, will happen, and at the most inopportune time.
Because
of this, I typically recommend that clients have a couple of extra
months' worth of emergency savings just in case you have that car
expense and medical expense at the same time that you are trying to look
for the new job. If you don't already know what your monthly expenses
look like, then use any of the budgeting tools your financial adviser
provides, or some other type of budgeting tool – you can find many good
free and paid budgeting tools online. Once you have this figured out, it's time to start saving.
Options for Emergency Savings
The
best way to save is to set up an account that is separate from your
primary spending account. Once this is done, you need to decide how
you'd like to go about saving the money. Do you prefer it to come
directly out of your paycheck and go right into the emergency fund
account, similar to your retirement contributions, or would you rather
have a little more discretion on the dollar amounts (i.e. the amount
could change from month to month)?
If you prefer the former, then
setting up automatic contributions from your paycheck should be as easy
as logging into your company's HR web portal or reaching out to the
company payroll group and providing them with the appropriate account
number and dollar amount you'd like to systematically transfer.
Typically, you'll be good to go within one to two payroll cycles.
If you prefer a little
more discretionary control over how much you move in any given month,
you could typically setup an ACH connection that allows you to move
money whenever and however you choose. Quite honestly, this is the easy
part. The tough part is choosing how you would like to invest the money
in your emergency fund. Please realize that I use the term "invest"
rather loosely, since emergency fund money really should remain in cash
or some type of cash alternative. The most appropriate options for your
emergency fund money are checking accounts, savings accounts, money
markets or certificates of deposit.
How Do You Choose?
Let's
take a closer look at your options to help you determine the best
method for you. Checking accounts typically pay the lowest interest rate
on your money, which at this time is right around 0.05%. Not exactly
something to write home about. Savings accounts and Money Markets can
pay quite a bit more, especially if you shop around a bit, even getting
up to 1% APY. The big catch with savings accounts and money markets is
that, due to FSB Regulation D, you are usually limited to 2-6
withdrawals in any given month. If you exceed these limits, you can be
charged additional fees that can quickly eat into your higher yield.
For
those of you who are looking for a little more yield and have more than
$20K already saved, you may consider CD laddering. It takes a while to
get the strategy fully implemented, but can pay off over time (if all of
this were couch potato-easy then everyone would be Warren Buffett).
Basically,
you divide your total emergency fund by five. Let's say, for easy math,
that you are starting with $25K. This means that one-fifth is equal to
$5K. Take that $5K and buy a 1-year CD, which you can get with an APY at
or above 1.25% right now. Leave the remaining in cash and set a
calendar alert on your phone. In three months, you will once again go
out and buy a 1-year CD at the prevailing rate — hopefully it's a little
higher than your last CD — leaving the remaining money in cash. If you
did your math right, at the end of 12 months you will now have four
active CDs totaling four-fifths of your emergency fund with the
remaining fifth sitting in cash. By laddering the CDs with shorter
duration (one year) you will constantly have money coming available to
you every three months, and you will also be able to take advantage of
any increase in interest rates. This can be the best of both worlds.
Beware of Over-Reaching for Yield
I
will never be able to stress this enough – for an emergency fund,
consider keeping your cash as cash and, at the least, a CD. I highly
recommend against seeking yield on emergency fund dollars by investing
in things like ultra-short bond funds, high-yield money market funds,
municipal resets or auction rate preferreds. Remember that it wasn't
that long ago that many retail investors discovered the reach for yield
could have dire consequences. In 2007 and 2008, folks were trying to eke
out a few extra dollars by investing in the aforementioned investments
only to be met with heartache. People that really needed their cash
found that the credit markets froze up, the auctions failed, ultra-short
duration bond funds like the Reserve High Yield broke the buck, and
even money market mutual funds were unable to pay out their investors.
All of these instances were resolved over time, but if you were some of
the unlucky few who actually needed cash in the midst of the Great
Recession, then it's likely you were out of luck. With these things in
mind, consider letting your cash be cash, or at least a short-duration
FDIC-insured CD.
Think about
how an emergency fund could function in your life. Relying on credit
cards in a true emergency may be a short-term fix, but cannot sustain
you over a longer period of time without potential financial damage (you can see how your debts are affecting your credit by getting your credit scores — many sources offer them for free, including Credit.com). Optimism can be a very good thing, but so can having a safety net for more challenging times.
Note: It's important to remember that interest rates, fees and terms for creditcards, loans and other financial products frequently change. As a result, rates, fees and terms for credit cards,
loans and other financial products cited in these articles may have
changed since the date of publication. Please be sure to verify current
rates, fees and terms with creditcard issuers, banks or other financial institutions directly.
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