Whether you call it a rainy-day fund, an emergency fund or a cash cushion, making plans to have significant cash available when bad things happen is fundamental to financial planning.
But what exactly constitutes an emergency fund? The most conservative definition--and most repeated advice--is cash equal to three to six months of living expenses sitting in a safe account earning minuscule interest.
But for many people, that could be overkill, said Sheryl Garrett, founder of the Garrett Planning Network, a group of financial advisers who provide money advice at hourly rates.
"I admire people who can do it, but the real question is: Have you done yourself any favors?" she said.
The downside is that money languishes in a low-yielding account, its value being eroded by inflation.
A cash horde might be safe, but in a crisis you simply need quick access to money, whether it's your own or someone else's, she said.
"I personally have never had a cash reserve to speak of. I think it would be most prudent to have at least six months of accessible funds, which is different than cash reserves. Anything you can get your hands on within a week, that to me is an emergency reserve," Garrett said.
Today, fewer than four in 10 Americans has an emergency savings account of at least three months of living expenses, according to a June survey by Bankrate.com. But those who have a cushion account take it seriously. They keep an average of $21,938 socked away.
So while it's true that cash is king for the safest emergency fund, some unconventional alternatives are available to the huge stash of cash. You'll have to decide what's right for you:
-- Save for bare-bones expenses. During a crisis, such as a job loss, spending should drop dramatically. The focus should be on such expenses as food, mortgage or rent payments, car payment and utilities. So using the rule of thumb, you actually need access to three to six months of spending on necessities, which is likely to be far less than monthly spending during flush times.
-- Start small. If you have high-interest debt, especially credit card debt, building a huge cash emergency fund is not a good idea. Paying off that debt is a higher priority. But it might be helpful to have a minireserve of cash to avoid adding more charges to the credit card.
One idea is to save $1,000, or one month's worth of necessary living expenses, whichever is larger. Then attack and eliminate the high-interest debt before beefing up a cash emergency fund.
-- Establish a home-equity line of credit. Homeowners could count it as part of their emergency fund, Garrett said. A home-equity line is an open credit line against the equity you have built up in your house. It's cheap or free to open a line of credit, and you pay no interest unless you use it. If you use it, the interest you pay is likely tax deductible.
Apply for an equity line before a crisis occurs and you don't qualify for one. A home-equity line is not a good choice for compulsive spenders who will use the credit line for non-emergencies.
-- Use a blended trio. This aggressive approach for homeowners has the advantage of providing savings for smaller emergencies without tying up large amounts of cash in low-yielding accounts. It calls for the emergency fund to be constructed with one-third cash, one-third home-equity line of credit and one-third access to retirement savings.
Borrowing against or withdrawing from retirement plans, such as a 401(k) or individual retirement account, is the least desirable option of the three. But it is money you can get your hands on if you were desperate. It would only be used if the emergency expense was so large it exceeded your cash and home-equity line. Look into your own retirement plans and find out how much you could get your hands on and how quickly, Garrett said.
-- Include non-retirement investments. Your regular investments might be mostly held in volatile stocks or in accounts that might charge an early withdrawal penalty, but these can be sources of emergency cash. True, an emergency might force you to take an investment loss, but addressing the crisis is usually more important.
-- Consider the two-income safety net. Two-income families have less of a need for a large emergency fund, especially if both earners make about the same amount of money. That's because a job loss, among the most serious of emergencies, doesn't wipe out the entire household income. A one-income family needs a larger contingency fund.
-- Raise your credit card limits. Using high-interest credit cards is a very common but lousy way to address a financial emergency. If you're responsible with credit cards and rarely carry a balance, however, it couldn't hurt to ask your card company to raise your limits if you do it the right way.
You must ask them to raise your maximum charge limit "without pulling my credit report." That way, the request will not damage your credit rating. In fact, it could help if you're successful, because part of the credit score is based on the amount of used credit compared with the amount of available credit. A second advantage is the higher limit gives you a source of cash during a temporary cash-flow jam.
-- Evaluate the bank of mom and dad. Borrowing from relatives or friends is dicey at best, and should probably be a last resort because it has ruined many relationships. But it could be a source of emergency money.
One idea is to formalize such a loan by writing down the terms. Consider using loan documents from a place such as LawDepot.com or using a company such as CircleLending.com to formalize the paperwork. "It's just a really smart way to handle a intrafamily loan," Garrett said. "It treats it as business relationship, not a handout."
Overall, you need to imagine a serious financial emergency, think about all your possible sources of quick cash and add to them until you're comfortable that you could weather the storm--because however you decide to construct your rainy-day fund, realize it will, indeed, rain. And you'll be needing an umbrella.
Gregory Karp is a personal finance writer for The Morning Call, Allentown, Pa., a Tribune Co. newspaper. E-mail him at firstname.lastname@example.org. For additional discussion on spending wisely, see the Spending Smart blog at http://blogs.mcall.com/spendingsmart/.