The Importance of an Emergency Fund

Today's tough economic climate can alter your life in the blink of an eye. Financial crisis can hit on your door in all shapes and sizes taking the form of a job loss, home or car repair, huge medical bills and so on. How many times have you gone to your bank only to discover that your account didn't feel as comfortable as it did one or two weeks ago? If this is your case and you don't (rightly) feel like getting another loan or further loading your credit card, you should consider the option of setting money aside in an emergency fund.

Why an emergency fund is important?

1) You avoid liquidating your 401k

An emergency fund helps you meet your financial obligations. Nowadays, the majority of Americans borrows from the IRA accounts or withdraws money from the 401k funds to anticipate any financial emergency. The paradox is that, although the 401k is a retirement plan and not a savings account, the government allows workers to borrow from their 401k plans. However, liquidating your 401k should be your last option because liquidating is subject to severe taxation and penalties. If you liquidate before the age of 59 ½, the retirement funds are subject to taxation and 10 percent penalty payment. So, it is better to set up an emergency fund than burdening yourself with additional charges in your already difficult financial situation.

2) You avoid overcharging your credit cards

In case of a financial emergency, most people turn to their credit cards. It is very tempting and extremely convenient to charge $2,000 on your credit card, especially when you have no other option. However, this never-ending spiral of credit card charging leads to high interest rates and a huge debt for which, sooner or later, you will need to find a suitable debt consolidation solution. On the contrary, if you have an emergency fund, you can withdraw money from there and avoid overcharging your credit card.

How much money should you set aside in an emergency fund?

Most financial experts suggest that keeping three to six months worth of your living expenses set aside in an emergency fund can provide you with the essentials to anticipate a financial emergency. For instance, three to six months of saved expenses normally cover up for a loss of job until you find new employment. Of course, it also depends on your marital status, how many people are there in your family, how much debt you carry and how much money you need to anticipate the unexpected financial crisis. In any case, it is better to plan for the unexpected than to let unforeseen circumstances control your life.

Where will your emergency fund be safe?

Since an emergency fund is money you keep for emergency situations, you should make sure to keep it safe. This automatically eliminates placing - even a small part of it - to a well diversified portfolio in the stock market to avoid any monetary losses. In contrast, you can place your emergency fund to a money market account (MMA) that allows you to withdraw your money up to six times per month with no penalty and is the most flexible solution to anticipate emergency situations. Also, with a MMA you have higher interest rates on your deposit.

Alternatively, you can place your emergency fund to a regular interest-paying checking account or a certificate of deposit (CD). However, although a checking account allows for numerous withdrawals and unlimited deposits, it does not offer high interest rate. As far as a CD is concerned, you will be charged with a penalty fee for withdrawing your money early so, although a safe account, it is not recommendable for financial emergencies as you cannot predict that the emergency will occur after your CD matures.

Another option is a money market mutual fund. This means that you will hold a portfolio of diversified, low risk, short-term securities with average maturity 90 days. The only consideration with a money market mutual fund is that it is not insured by the Federal Deposit Insurance Corporation (FDIC) like the MMAs, CDs and the checking accounts and therefore, they incur a slightly higher risk which is compensated by a slightly higher interest rate.

Once you set up your emergency fund, make sure to put your savings on auto-pilot. In that way, you will able to know each month how much money you have to the penny and plan your financial future accordingly. Focus on your household necessities including your rent/mortgage, car insurance, utilities, groceries and health care and be prepared to anticipate other important basic needs by adding an extra amount as cushion to your monthly budget. Finally, make sure to pay yourself first and actually save your money to your emergency fund. Decide on a percentage of your monthly income that you want to set aside and transfer it automatically to your emergency fund to make sure you will save it.

Sources:

http://www.finweb.com/financial-planning/the-importance-of-an-emergency-savings-fund.html

http://financialplan.about.com/od/savingmoney/a/emergencyfund.htm

http://money.howstuffworks.com/personal-finance/financial-planning/money-market-accounts.htm

http://www.investopedia.com/terms/c/checkingaccount.asp

http://www.investopedia.com/terms/c/certificateofdeposit.asp

http://www.investorwords.com/5922/money_market_mutual_fund.html