Saturday, July 15, 2006

What Happened to the Emergency Fund?

One of the first things that I learned about personal finance from my grandfather is to have an emergency fund of six months worth of expenses. This still seems absurd to me in this day and age and given my income to debt ratio. Even though I think an emergency fund cannot be underestimated, according to a Federal Reserve survey, 8% less people even have savings accounts since 2001. The savings mentality is drifting away. Instead large percentages of people's net worth is in retirement accounts.

This is a key mistake for most people. They confuse 401k loans and home equity lines of credit with emergency funds. In my opinion, neither 401ks or home equity should be touched until you are approaching retirement. Instead, a separate account (either savings or money market) should be set up and used for emergencies.

That is the perfect self-insurance plan. It is for just what it sounds like - emergencies. Working at my first job out of college was great, but there were lay offs. Luckily I was not one of those who lost their job, but it made me realize that anything can happen. Even if you are smart and talented you can still lose your job, get into an accident or have some other emergency really throw you for a loop.

Even still, I think that 6 months is too much for most people, but 3 months is reasonable. Together my partner and I have been saving for several years now and the fund is still not quite there. Some of it was depleted recently to pay off a credit card that will save me several hundred dollars in interest over the next year.

Even small amounts contributed regularly (right after payday but before bills) is best. These will add up over time and make sure that once it is a sizeable amount that you get it into a high-yield account so that you will get substantial interest.


Source: http://www.federalreserve.gov/pubs/bulletin/2006/financesurvey.pdf

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