With all the economic turmoil resulting from increased oil prices, the bursting of the real
estate bubble and the credit fiasco, we thought it might be helpful to review the
requirements for an emergency fund. Lack of an adequate emergency fund can result
in excessive use of credit cards and the associated high-interest-rate debt.
First and foremost, everyone needs to establish an emergency fund. Financial planners
typically recommend that an emergency fund equal to three to six months of fixed and
variable living expenses be maintained in liquid assets (cash or cash equivalents). This
is to avoid having to liquidate investments at a possible loss as a result of an
emergency.
An adequate emergency fund for many will easily top $10,000 to $ 20,000 or more
depending on your situation. Often, we are amazed to see that clients have placed their
emergency fund in a bank savings account earning a fraction of a percent in annual
interest. With a little effort you should be able to find safe money market or money-
market-like fund that pays two to three times what most bank savings accounts pay.
The exact amount of emergency funds you should have can vary based on your
personal situation. An emergency fund of three months may be sufficient for families with
both spouses earning a solid income with good job security or retirees with guaranteed
pension and social security income. On the other hand, if you’re either unmarried or
married and only one spouse works or job security is an issue, then it’s important to
have at least six months of living expenses socked away. People with highly variable
income stream (such as sales people whose earnings primarily consist of sales
commissions), should allocate even more. Individuals working in highly volatile or
cyclical industries should also set aside more in their emergency funds. In some cases,
we would recommend an emergency fund equal to a full year’s needs.
And, even though both spouses have good paying jobs, their financial situation may
dictate a much larger emergency fund. Consider the example where a dual income
couple is able to meet monthly payments but has taken on two large car loans, a large
home-equity loan, and has numerous credit card balances. If one of the spouses
suddenly lost their job, their need for an emergency fund is even greater than what the
guidelines call for.
While it might sound extreme, it is not out of line to suggest that married couples should
live on just one spouse’s income unless they have substantial savings to fall back on.
With today’s turbulent economy, even the seemingly safest job can disappear over
night. Young, newly married couples can easily fall into the two income trap. They get
used to two incomes; buy a larger house, two brand new cars and end up forced to use
credit cards to pay ordinary bills. Their budget gets even tighter when they have a baby
and the wife decides to cut back on her job. Medical expenses, diapers, baby furniture
and clothes add to a now tight budget. Without an adequate emergency fund in place,
they can get into big trouble if they do not make the necessary budget adjustments in
time.
Finally, college graduates should be especially aware. Often, they go overboard with
the sudden availability of cash from their new job. They buy a new car, flat screen TV,
new clothes, etc. If are not careful to hold off on some of these items and establish an
emergency fund, they may be setting themselves up for a serious debt problem.
Our economy is undergoing some major changes that will impact us all. Credit will not
be as readily available to us and the need to pay for unexpected expenses will have to
come from cold hard cash. The bottom line? Don’t ignore your emergency fund and
make sure it’s big enough to handle the problems you least expect.
David C. Patterson, CFP® and Erin Preston, CFP® are the owners of Patterson
Advisors, LLC, a fee-for-service-only financial advisory firm. Patterson Advisors, LLC is
a Registered Investment Advisor, registered with the State of Michigan, helping clients in
Waterford, Clarkston and Royal Oak, Michigan as well as other Oakland County,
Michigan communities . Visit www.pattersonadvisorsllc.com for more information or call
248-674-2108.
Published in the Oakland Insider, October, 2008
Need for an Emergency Fund is Greater Than Ever
By David Patterson and Erin Preston (formerly Patterson)