Disaster Cash: How Much Do You Need for a Good Night’s Sleep?
Financial disasters come in many different forms.
In the case of my own family, it came last month in the form of a 1986 red and brown Chevy van whose driver apparently never saw us.
Luckily, only metal and money were wasted in the collision. Insurance covered the total loss of the car, but buying a new vehicle and paying off $1,250 in repairs that had been completed just before the collision were an unexpected financial jolt.
Events like this happen to thousands of people every day and can affect family finances for months and years.
And yet many people don’t prepare for disaster, figuring it won’t happen to them or that they have other resources--notably credit--to tide them over.
In fact, the financial planning community is split on the issue. Although the conventional wisdom for decades has been that consumers should set aside up to six months of expense money to cover emergencies, many advisors suggest that strategy sacrifices too much income to an event that is not likely to happen.
Of course, many people simply don’t prepare.
Last spring, financial software maker Intuit conducted a survey that found that one third of all Americans “spend” their paychecks before actually getting the money. One in 10 people acknowledged that they have relied on loans from friends or family to get through a pinch.
Meanwhile, the number of personal bankruptcy filings is soaring, with more than 1.25 million cases filed in the year ended June 30, and a projected 2 million cases on the horizon next year. (The nation’s burgeoning credit card debt is considered the root of the mushrooming bankruptcy statistics.)
Ironically, the people who can most afford to set up cash reserves are usually the people with enough cash to survive a catastrophe anyway.
“It’s all risk management,” says Judith A. Shine of Colorado-based Shine Investment Advisory Services. “If you set the money aside, you are acting like there is a 100% chance something bad will happen. If you invest it in the stock market, there is about a four-out-of-five chance it will go up. You have to balance those risks, the chance of an emergency and the possibility that you won’t be able to cover it.”
What actually constitutes a financial emergency depends on your viewpoint. Most advisors want to guard against disability or loss of income. Material goods, such as car and home repairs, create problems, but don’t necessarily represent real disasters.
Regardless of which type of disaster you are guarding against, you are investing for safety rather than growth. You get your return in peace of mind and in the interest costs you will avoid by not having to borrow when disaster strikes.
Consider your emergency cash the way you would think of insurance: It is designed to pay for what you can’t afford to lose. With that in mind, ask yourself the following questions when deciding what kind and size of emergency fund to establish:
* How steady is my income?
If your job is secure and your paycheck is steady, a small emergency fund may suffice. But if you work on commission or do seasonal work, you need a bigger stake.
You should also consider how employable you are if your job is eliminated. If you could walk up the street and have another job in an hour, you need less protection than someone who needs six months or more to find a job.
Many advisors now believe that one month’s take-home pay is a sufficient reserve for anyone who is in a steady employment situation, and especially in two-income families where the loss of one job would not wipe out all cash-flow.
* How good is my insurance coverage?
The better your protection, the smaller your emergency needs. But be sure to check out deductibles, eligibility periods and more. If, for example, a disability policy only kicks in after you have been off the job for a month, you would want to have at least a month of expense money in reserve.
* What are my expenses?
Base your emergency reserves on your needs, not your income. There are a lot of things that can be eliminated during emergency situations, but eating, for example, is not one of them. Use your minimum expenses as a guide to what you will need to have in reserve.
* What are my alternatives?
The loss of our car, for example, left choices ranging from public transportation to dipping into long-term savings to buy a new vehicle. My wife and I had planned to buy a new car next year; the lost repair money and the change in cash flow entered into our decision on a replacement.
Remember, what might be ideal from a consumption standpoint doesn’t always fit the budget.
Emergencies change your plans, both in life and in finances. Examine all your options and take the one that helps you recover and move on, even if it is not the perfect choice.
* What other resources do I have available?
You may have financing options to ride out a storm, the question is whether you will want to tap them.
For example, you can borrow from a 401(k) or retirement plan or look into hardship withdrawals, but that could jeopardize your retirement. Selling taxable investments means paying Uncle Sam for your gains. A home-equity credit line can solve a lot of problems, but also puts your house at risk if your financial crisis stops you from paying it back.
* Have I set aside enough?
The happy medium with emergency reserves is a balance you can live with. It may mean that your emergency funds are drawn down regardless of the type of problem--from replacing the car to replacing a lost income--and then replenished when new cash becomes available.
It could also be that you simply set aside enough money to sleep well at night, comfortable that you have examined the worst possible scenarios and have enough money to get by.
*
Charles A. Jaffe is personal finance columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com
