MOST AMERICAN families are living paycheck to paycheck. This was highlighted by the recent government shutdown. Many federal workers quickly found themselves in financial trouble, when they didn’t receive their regular pay. In fact, a Federal Reserve survey found that four out of 10 Americans either couldn’t cover a $400 emergency or, to do so, would need to borrow or sell something.
That brings us to a question I’m often asked: Why do financial advisors insist clients establish an emergency fund? After all, that cash will likely sit in a low-interest checking or savings account, where it lags behind inflation. You might be wondering whether the money could be put to better use by, say, paying down debt or investing through a brokerage account.
My response: No matter how good your financial plan, the steady progress you’ve made over the years could come to a screeching halt if times turn bad. A financial emergency is just that—an emergency. Often, the bills are high and need to be paid promptly. If you put off payments, you could wreck your credit score, get hit with financial penalties and you might be charged hefty amounts of interest. This can leave you in a financial hole that’s difficult to escape.
A 2017 study from the Federal Reserve Bank of St. Louis illustrated just how important it is to have a cash buffer. The study found that having more liquid assets and fewer debts reduce the chances of financial hardship. That makes sense. Most interesting to me: Having cash on hand was the greatest predictor of success.
The report’s authors, Emily Gallagher and Jorge Sabat, put it this way: “Our findings suggest that households should be encouraged to maintain at least a small buffer of liquid savings, even if the cash in that buffer is not being used to pay down high-interest debt.”
Having an emergency fund was found to reduce the chances that folks fail to pay their rent and mortgage, miss payments on everyday bills, skip medical care or go without needed food. The bottom line: You should establish a cash buffer before taking on other financial goals.
The fact is, some of life’s most critical expenses can’t be put on a credit card. The rent, mortgage and many utility bills must be paid on time and from your checking account. Living without a small cash buffer puts these necessary payments at risk, should you find yourself without an income.
Need to boost your cash buffer? In today’s gig economy, the opportunities to earn extra cash are almost endless. Look for ways to use your free time to make money. That might mean driving for a ride-sharing company, renting out a spare bedroom or selling unused clothes on eBay.
If you don’t currently have a cash buffer, your initial target should be $1,000 in a separate savings account. This amount will likely cover your insurance deductible, if you need to make a claim. After you reach $1,000, turn your focus to paying down high-interest debt.
Once that high-interest debt is paid off, aim to establish what I consider a full emergency fund. This amount varies, depending on your personal circumstances, but generally you’ll want to sock away between three and six months of living expenses. Entrepreneurs and those with little job security should consider a larger emergency fund, perhaps equal to one or two years of expenses. Retirees will also want to hold a few years of spending money in a cash reserve, so their lifestyle won’t be threatened by hefty medical expenses or a financial market downturn. Sound excessive? Remember, at times of trouble, that cash buffer may be your most prized asset.
Ross Menke is a certified financial planner and the founder of Lyndale Financial, a fee-only financial planning firm in Nashville, Tennessee. He strives to provide clear and concise advice, so his clients can achieve their life goals. Ross’s previous blogs include More to Come, Pass It On, A Great Gift and Bad Timing. Follow Ross on Twitter @RossVMenke.