Monday, February 8, 2010

Fin 101- Emergency Savings

Got money? Tax refund, a bonus or a win in a Superbowl box, what to do?

Let's say that you've recently received a nice chunk of money. As images of large television screens and exotic vacations dash in front of your eyes, you ask yourself is there a better use for this money?

One of the biggest problems facing the average American, is a lack of emergency savings or insufficient emergency savings. At the very least, before planning to make any large purchases or retirement savings, a person should have at least 3 months of living expenses, 6 months is safer and a year is even better.

Unfortunately many people believe that they can charge things and pay them off with the next pay check. No one considers how are you going to upkeep your car payments and rent and credit card balance if for some reason you lose your job, or become sick for a period of time (government benefits usually don't kick right away.)
This also effects families which depend on dual incomes to keep up with most of the bills.

Imagine a couple who in total brings in about $5,000 a month after tax. They are doing relative well, they usually have about $1,000 extra per month that they use for a vacation, house renovations and purchases. They recently had a baby and have almost no savings, after they fixed up the den and the baby's room. Now imagine what would happen if one of the parents suddenly found themselves out of work for two months. All of a sudden $5000 turns into 2,500 and instead of having $1,000 extra, they now have a $1500 monthly deficit. (Please don't pick the numbers apart, they are just used as examples, you can certainly lower or increase them to fit your need. Just be aware that many of the higher earners are also higher spenders.) Many times, they turn to credit cards and charge their problems away. As long as the parent is able to find a job soon, all will be fine, they will pay a little bit of interest and pay off the credit card debt... that is, unless nothing else bad happens. Bad things have a tendency to clump together, and a leaky roof, or car trouble can quickly turn this small problem into a serious issue.

So, now that we know the importance of having emergency savings, let us take a closer look at what makes a good savings account and what does not. The best emergency savings are those that both earn money for you and are very liquid (meaning you are able to get access to the money fast). If you have money saved in a 401k or an IRA, or other type of retirement account, this is great, but that money is not liquid, you can't take it out right when you need it without going through paperwork, possible tax penalties and a short waiting period. Having your emergency savings in stocks might force you to sell something at a bad time, which is something you always want to avoid. A long term CD is also not good for emergency savings. If you need money right away, you'll have to break the whole Cd and usually pay penalties. The best candidate is either a high yield savings account, a high interest reward checking account or a bank money market. In short, you want to be able to have access to money right away, and you want the money to have some kind of return while it sits.

Make sure all of you as well as your loved ones have an adequate emergency savings reserve. In the next few posts, I'll talk about good ways to start them, even if you think you don't have any extra money to spare.

P.S. This is a very good site for finding high yield accounts to house your emergency savings.


1 comment:

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