Are You Driving Without a Spare Tire?

February 17, 2015

Not having an emergency cash reserve is like driving around with no spare tire in your car. Sure, everything is fine today, but what happens when you unexpectedly lose your paycheck? How would you cope with the loss of a job, extended illness, or any other unexpected major expense?

Fragile households 

Financial planners recommend that families hold three months of income in an emergency savings fund. A public policy group surveyed American families in the fall of 2014 and found that 55% of families had less than one month of liquid savings. Cash on hand, checking and savings accounts could not replace the first month of income in the event of a family catastrophe.

This finding was collaborated by the Federal Reserve’s Report on the Economic Well-Being of U.S. Households. The Fed survey showed that only 39% of households could scrape up enough liquid savings to cover three months of spending. Being dependent upon a larger safety net improved the chances of weather a storm.

When asked, “If you were to lose your main source of income… could you cover your expenses for 3 months by borrowing money, using savings, selling assets, or borrowing from family/friends?” Fifty-six percent said yes. This suggests that while most households are unprepared, a large number are expecting to rely upon their families and social networks for support.

In order to illustrate just how fragile family finances are, the Fed asked participants if they would have the cash to cover a $400 emergency. Just 48% said that they could pay that bill with cash, money in a checking account, or a credit card that they would pay off in full at the end of the month.

The cost of being wrong

We started with the metaphor of driving your car with no spare tire. The whole thing works well until you have a flat tire. Having no emergency savings works the same way -- if you have a loss of income or a sudden unexpected expense, the cost to you can be catastrophic. Just like being stranded on the side of the roadway, you will have to make some very bad choices.

Borrowing from friends and family can be very uncomfortable and strain relationships. Selling assets in a panic can result in huge losses and a lot of personal anguish. Maxing out credit cards can cost an astronomical amount in finance charges. Payday loans can lead to a death spiral of interest charges. The financial path can be ruinous as families fall into personal bankruptcy due to unexpected events.

How to build an emergency fund

The hardest part about building an emergency fund is starting. First, find a few dollars that you can save on a regular basis. This is easiest to accomplish when you have an unexpected drop in spending which leaves you with some unallocated cash. Recently the price of gasoline has fallen sharply and a tank of gas is costing about $10 less than it used to. Rather than spending the windfall, save the difference and start your emergency cash fund. Use any unexpected savings to start.

How to build your savings

Sock drawers: It sounds simple and a little corny but it works. Take that first few dollars and squirrel it away in a place where you will not be tempted to spend it every day. A secret stash of cash is easy to hide and easy to add too on a daily or weekly basis. Just ten dollars a week from saving cash on gas adds up quickly.

Savings accounts: Once the sock drawer has grown to an amount that you are not comfortable with having in your home move the stash into a savings account. It may not pay much in interest but it will keep it safe. Your bank or credit union will set up a separate savings account for you so you can keep your emergency money separate from your regular accounts.

Certificates of Deposit (CDs): Once you’ve accumulated a few hundred dollars you might want to roll some into a term deposit. By committing your savings to a one year term or longer, you can get a higher rate of interest. If you need the money sooner, you can get it back but will have to pay an interest penalty.

Saving bonds: If you want to earn a slightly high yield you can buy savings bonds directly from the US Treasury by rolling some of your savings into a US Treasury Savings Bond. These bonds are horribly old fashioned but still a good method of savings for emergencies. Currently Savings bonds are earning 1.46%, which is more than you can get on your savings account.

Whole Life policies: This is a longer term strategy to improve your financial security. By investing in a whole life insurance policy you provide a safety net against loss of life. A secondary benefit of owning a whole life policy is that it allows for the tax free accumulation of a cash value within the plan. Over time this builds up and becomes a valuable asset that can be used in emergency situations.

Be financially confident

Saving through any of these methods is like having a financial spare tire. Over time, you can work to save enough to equal three months of income. Then if you lose your job, have an unexpected medical bill, or any other large unexpected expense you will have the financial resources to get yourself going again.

What's the status of your emergency fund?