A Forgotten First Step in Wealth Creation: Emergency Funds

Be prepared for life's unexpected by taking the steps today to create an emergency fund.

An epidemic of stress grips America. Despite a low unemployment rate, 62% of Americans admit to feeling stressed about money with 31% feeling stressed by it all the time and losing sleep, according to a survey by investing app Stash.

In the short term, that level of stress can cause health problems, reduce enjoyment of life, strain relationships and reduce productivity at work. Over the long term, many people's fears of falling too far behind may come true if there is a decline in the economy, a health problem or a temporary income loss. Without adequate funds to weather those storms, vital bills go unpaid and assets are depleted.

This fear has a basis: 40% of American households have less than $400 in emergency savings, and more than half have less than $1,000. Very few have the recommended three to six months' worth of expenses in a savings or money-market account.

We can rarely predict when an emergency will happen, but we can be 100% certain that an unanticipated financial hit will strike eventually. Emergency funds are for the expenses we know we will incur at some time; we just don't know when. Expenses such as medical bills, car repairs, home repairs and other inevitable happenings necessitate keeping cash on hand. The adage of pay yourself first applies. For many, emergency funds serve as a first and integral step in financial planning.

Below are the basics to establishing, maintaining and utilizing an emergency fund.

How Much?

The first step in determining an emergency fund goal is to calculate what expenses must always be maintained. For example, rent, food, utilities, gas, insurance and car payments can't be delayed. They must go into the calculation of monthly nondiscretionary expenses. Money toward a luxury vacation or other discretionary expenses can be excluded, because you can cut them.

Experts recommend three to six months of nondiscretionary expenses in reserve, at a minimum. Circumstances such as a serious health condition or an upcoming mass layoff in your industry may necessitate even more.

It's recommended that single-income families keep at least six months' worth of expenses 100% safe in a money market or savings account. If your total monthly expenses are $1,000, then $6,000 is suggested for your emergency fund.

Dual-income households may opt to go as low as three months and put additional savings into low-risk investments that generate returns that beat inflation, provided that both incomes are steady and stable. That can serve as the start of an investment pyramid, which is formed by first creating a base of safer investments and then placing smaller amounts of money in more volatile assets.

Having cash on hand allows you to pay for unexpected expenses without having to take out risky 401(k) loans, sell equities or take out a home equity loan, all of which can have a devastating effect on net worth. For a wealth-accumulation plan to succeed, it's important to be able to handle contingencies without selling assets or taking on debt.

How to Save

So few Americans have adequate emergency savings for several reasons, including high living expenses in urban areas, relatively low pay in rural areas, a lack of job security and failure to create an effective financial plan. Although people have limited control over economic conditions, they can control and create an effective spending and savings plan.

The spending plan should find ways to combat relatively high living costs and economize. When spending is planned, it's then possible to create a realistic, disciplined savings plan. Most people can work their monthly budgets to increase savings. Even if you have to start small, the important thing is to just start.

For example, if you can save $250 per month with careful spending, that's $3,000 in just one year. To make sure you hit the $3,000 goal, consider setting up an automatic contribution from your paycheck.

Where to Hold

Emergency funds must be immediately available and 100% safe. Until you have enough to cover emergencies such as car repairs, medical bills or income declines, savings should go directly into a savings or money market account. Online banks and money-market accounts provide much better interest rates, which can be applied toward your savings goal.

The primary goal of a savings account is to provide a higher rate of return than if you just locked cash up in a safety deposit box. Online banks offer interest rates that are often above what brick-and-mortar banks pay. Money-market funds also tend to pay higher interest rates than savings accounts.

Many of those accounts have restrictions, including limiting withdrawals to six per month. Because disbursements from emergency fund accounts are meant to be occasional, those restrictions shouldn't matter. For example, if temporarily unemployed, you can transfer the money needed for the next month's expenses to your checking account with one transaction.

When to Use

The goal of an emergency fund should be to prevent indebtedness and protect assets.

Emergency funds should be built with the expectation to actually use the money in the future. Often, people make the mistake of charging emergency expenses to a credit card and keeping money in the bank. This can create a false sense of security. Because credit card interest rates are vastly higher than any savings account rates, carrying a credit card balance will leave you worse off than if you were to just draw on savings. Remember, you still have the open credit line should it be needed later.

Creating an emergency fund provides the best antidote to the epidemic of financial stress. Knowing those inevitable financial hits are covered allows people to relax and focus on more productive things than financial anxiety. Since emergency funds cover contingencies, they allow investors to increase their money without fear of having to sell assets when the market is disadvantaged.

By building an emergency fund, you take the first step in a longer-term wealth-creation plan. Once you have sufficient savings to navigate life's curve balls, you're ready to enact a comprehensive wealth-creation plan involving diverse investment options.

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