Emergency funds

You’ll sleep easier at night if you’ve planned ahead to cover an unexpected need for cash.

Even though you might have a grasp on your current financial situation, you’ll need to be prepared if you hit a bump in the road. That’s why having money set aside to see you through is essential. For instance, what if you had a serious accident and couldn’t work for several months? Or, what if you lost your home and all of your possessions in a fire or a flood?

Although thinking about issues like these is never fun, being ready for the unexpected is one of the keys to financial security.

Preparing for the unknown

All solid financial plans should include sufficient cash reserves to offer protection when financial emergencies arise. To be even better prepared, you might organize your cash reserves into two categories: a rainy day fund and an emergency fund.

Your rainy day fund might hold $1,000 to $5,000 that you could use to cover day-to-day financial setbacks like a computer that has to be replaced, damage to your roof, or essential car repairs. While you can usually put these expenses on a credit card, having the cash set aside in a savings or money market account to pay the expenses is often a better idea. For one, it can help you to avoid interest charges, which only make the unexpected costs even more expensive.

Emergency funds, on the other hand, are designed to protect you during a major financial hardship like a job loss, or an illness or injury resulting in expensive medical bills, hospital bills, or an extended disability leave. These funds should hold larger sums of money, often three to six months’ worth of living expenses. And, if you’re single, you may want to increase that amount to a year’s worth of living expenses, especially if you won’t be able to turn to family members for help.

An emergency fund will take more time to accumulate than a rainy day fund, and should take precedence over other types of saving until you have reached an accumulation you’re comfortable with. One approach to speed up the process is to arrange to have a specific amount transferred from your checking account to a savings account twice a month or every time you’re paid. Though it reduces your take-home pay, you’re less likely to miss the money than you would if you had to move the money yourself each month. And you’re certainly less likely to spend it on something that doesn’t meet the definition of emergency.

The one exception is money you contribute to an employer-sponsored retirement savings account, especially if your employer matches some or all of your contribution, since this money typically grows tax deferred and you benefit from the added amount of the match.

Choosing the right investments

Keeping your rainy day funds in safe, liquid accounts, such as money market accounts, ensures that your money will be easily accessible with little or no loss in value if and when you need it.

The more money you keep in your emergency fund, though, the more types of investments you may want to make. Because costs associated with even the most serious emergencies tend to be spread out over several months or longer, safe investments with longer maturities and higher paying interest rates will probably have time to mature before you need the cash. In this case, you want to consider using bank certificates of deposit (CDs), US Treasury bills with terms of up to a year, or short-term Treasury notes with terms of two years, for these savings.

Since keeping too much money in low-paying, interest-bearing accounts can leave you vulnerable to inflation over the long-term, you may also want to invest some of your emergency money in a conservative, balanced portfolio of stocks, bonds, and mutual funds or exchange traded funds (ETFs). You can always sell the investments if you need the cash, but if you don’t have to tap your savings for an emergency, you’ll have the potential to earn more in the long run. The risk, however, is that you might lose some money if you need to sell on short notice and the market price of your investment has dropped.

Staying on top of your savings

Your rainy day and emergency funds need regular attention, just as the rest of your investment portfolio does. If you tap the funds to pay for an unexpected expense, big or small, you’ll want to replenish the account as quickly as you can. If you’re aware that things in your personal or professional life are a little rocky, make a real effort to boost your reserves in the short term. You can always reallocate the extra money to other investments if things work out better than you feared.

The better prepared you are to handle a financial emergency that comes your way, the more confident you can be about getting through it, and the stronger the chances of protecting your long-term financial security.

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This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.