Structuring an Emergency Fund

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Most advisors recommend that you need to maintain enough readily accessible cash as emergency fund. This should be enough to cover your expenses for 3-6 months. This is a sound recommendation for most

. In some cases though, such as an entrepreneur launching a new business, or in recessionary periods when new jobs are difficult to find, you should have a larger emergency fund (but is saving 8-12 months of expenses even possible?). But, how do you structure this emergency fund? At first, you may be tempted to save your entire emergency fund in a savings account, but this is not necessary. You can designate several different sources of emergency funds. To do this properly, you need to consider the liquidity of the vehicles you use or designate as a source of emergency fund as well as the order in which you should access them. It is a great idea to spread your emergency fund in multiple accounts, specially in these times when soundness of financial institutions maybe in question.

Here is what I found works in my experience. I take the liquidity, returns and tax considerations into account when formulating this plan.

  1. Accessible anywhere, use if cash needed right away – Unused balance on your credit cards: What do you do if you need to make a purchase right away and you have no access (or time to access) a bank or an ATM machine? Maybe you need to make emergency travel arrangements, or maybe you are stuck in an unfamiliar city or country? Using a credit card is an obvious choice. Always make sure that you carry atleast two major credit cards (Mastercard, Visa or American Express) as not all cards are accepted everywhere. In addition, do not max out on your credit, ever. I personally make sure that I never carry more than 25% of the credit available to me on my cards at any time. Credit cards can be the most liquid source of emergency funds available. Always treat credit cardsĀ  as a temporary source of emergency funds. Which means you need to make sure you payoff the balance at the end of the month.
  2. Accessible at most places, use if cash needed between now and 1 week – Savings and Checking accounts, ATM/debit cards: These accounts are also very liquid. It is always wise to keep some ready cash available in these accounts. I recommend that you maintain at least one checking account and one savings account. Keep the bulk of free cash in the savings account so it can earn reasonable interest. However, since many banks restrict the number of monthly transactions from a savings account, use the checking account to pay bills and draw money from and replenish from the savings account when necessary. I do not recommend keeping more than a weeks worth of expenses in a checking/savings account. This gives enough time to access less liquid accounts if necessary. At the same time you can keep money invested in higher returning vehicles.
  3. Use for cash needed between week 1 and month 2 – Money market funds: These are available through banks and many mutual fund companies and your stock broker. These funds are generally very safe and pay interest that areĀ  higher than a regular savings account. Funds can be accessed on any business day, so these are highly liquid. However depending on your method of accessing funds, it may take up to a week to receive a check, depositing it and the funds becoming available at your financial institution. Quite a few of the fund companies offer free checkwriting privileges on these accounts. This can shorten the fund access time significantly. So if you have this available, make sure to sign up. Also, be aware that even with check writing privileges, there may be a minimum check amount threshold/ That means you may not be able to write a check to pay, for example, your utility bill. Also, care should be taken in selecting appropriate mutual funds, pay attention to the expense fees and loads. Less is better. Keep enough cash in a money market fund to cover your expenses from week 2 to 1-2 months. You can of course keep more depending on your asset allocation strategy.
  4. Use for cash needed month 2 and beyond – Treasuries, Short term corporate/government bonds, Certificates of Deposit, Home Equity Line of Credit: These are generally safe investments that can be used as a source of emergency fund. Depending on your custodian and the product, you may be able to access funds right away or you may need to wait until the draw window. However, you may want to delay accessing these funds as much as possible as they typically offer better returns, or in case of HELOC, you actually end up paying interest. Also, try not to use a HELOC unless you have significant equity in the house otherwise the market fluctuations can put you upside down on your mortgage.
  5. Avoid using or delay using if you can – Margin accounts at your brokerage: Expensive source of emergency funds but it could still be cheaper than selling off your investments. While using margin maybe an integral part of your investment strategy, I would advise leaving some flexibility in for use in emergencies. Typically I advise signing up for a margin account and not using it unless there is an emergency.

There are other sources for emergency funds such as your retirement savings (401K, IRA, etc) or even your children’s education fund. We do not recommend tapping into these sources. Ever. Emergencies are temporary, these savings are long term. Keep them separate. And make planning for financial emergencies an essential part of your budgeting process.

As with any financial advice, please consult with your advisor who is more familiar with your situation. Please let us know what you think or if you have other ideas for managing your emergency fund