Despite what much of the mainstream media would have you believe, the sky is not falling, the value of your home has not depreciated to zero, and the economy is not about to enter into the second coming of the Great Depression of the 1930’s. That said, it comes as news to no one that the economy is definitely in a down cycle. Whether we are “statistically” in a recession is unclear, and, frankly, really only important to economists. What is important is that times are tough for many, and, while there are signs that things may turn for the better soon, its always a good practice to ‘hope for the best, plan for the worst’. Towards that end, now’s a very good time to review a number of questions about emergency funds.
First – What is an emergency fund? An emergency fund is, as the name suggests, is an amount of money that you set aside for those times when your monthly cash flow is either stretched – due, for example, to an unexpected medical bill or home repair – or, temporarily stopped – due, for example, to a layoff.
How much should you keep in your emergency fund? Generally, you it should contain an amount equal to at least five to six months worth of your necessary living expenses (expenses you can’t decide not to pay – rent or mortgage, food, gas, insurance, heat, etc.) or eight to ten months of living expenses if you’re self-employed. So, for example, if your monthly living expenses equal $3,500, your emergency fund ideally should contain $17,500 – $21,000 ($28,000 – $35,000 if you’re self employed).
Where should your keep you emergency fund? Your emergency fund should be kept in a safe, liquid account that guarantees the full amount will be there and easily accessible if and when you need it.
What qualifies as a safe, liquid account? Savings or checking accounts covered by deposit insurance, or insured (either by the government, or by the large institution offering it) money market funds (for example a cash reserve account at one of the large brokerage houses.
A few final questions. Does a CD qualify as a “safe, liquid account”. Technically, no, since the money is not fully liquid. Should non-money market mutual funds and individual stocks be considered part of your emergency fund. NO! Why – because they are not fully liquid, and, much more importantly, they aren’t completely safe. Finally, can a home equity line of credit be considered an emergency fund? Again, NO! Why? To begin with, a home equity line is not savings at all, but a vehicle that gives you access to the equity in your home, equity which you only want to tap for “emergencies” as a last resort, and, as we’ve seen of late, access to equity that can quickly disappear (either because the value of – and thus the equity in – your home goes down, or, because, the home equity line is suspended (as more and more lenders are doing to home equity lines – even those of long time, very good borrowers – during the current ‘credit crunch’).