Most financial planners advise their clients to have money set aside in an emergency fund. Occasionally my clients ask me why they need to keep money on hand for emergencies. If you’re like most Americans, once you’ve paid your credit card bills, mortgage, and your other bills, there’s not much left of your paycheck. If you’re someone who lives far below his or her means (by this, I mean that you have two or three thousand dollars a month or more left unspent from your income every month) you have the capacity to cover many typical unexpected expenses, like the sudden failure of your heating system in the middle of winter. If that’s your situation, you’re in a position to cover emergency expenses from your cash flow – unless the emergency happened to be the loss of your job, in which case you’d still be in trouble. The fact is, though, that few households have large amounts of cash flow that go unused from month to month.
Consider the following imaginary situation. You’ve just received a raise. You’re decided that for the first time in years, you won’t live paycheck-to-paycheck. After taxes and other withholdings, you now have $250 a month beyond what you’ve been spending. You resolve to set that amount aside and save for next summer’s vacation.
You return home from work the day after your decision and discover that the inside of your refrigerator is lukewarm. The refrigerator is 10 years old, and you know in your heart of hearts that paying a repairman to fix it is a waste of money. You need a new fridge, and you need it now.
You make a hasty trip to your local appliance store and find a refrigerator that they can deliver tomorrow. The cost, all told, is $1,200. You wince as you hand over your credit card, but you realize that you don’t really have a choice – you can’t function without a working refrigerator.
Driving home, you notice that your car’s air conditioner doesn’t seem to be putting out cold air. Apparently this isn’t your week for Freon-related technology. The next day, you drop the car off with your mechanic. He reminds you that you’re overdue for your 60,000 mile maintenance, so you tell him to take care of it while he has the car. At mid-morning, he phones to tell you that he’s found the air-conditioning problem. He has further news – one of your disk brake rotors is in bad shape, and you need a brake job. You can’t drive without brakes, so you authorize the work. The total damage when you pick the car up is $1,300, which also goes on your card. You comfort yourself with the knowledge that you’re racking up lots of frequent flyer miles.
A couple of days later, there’s a heavy thunderstorm at midday. You return home to find a dark wet spot growing on your living room ceiling. Uh-oh….
A week later, you’ve got bids from three contractors (remember, it’s an imaginary scenario) for the replacement of your 12-year-old roof. The roof should have lasted longer, but the last contractor – your brother-in-law – did a lousy job. Anyway, the bids are all around $12,000, which makes your head hurt. These guys don’t accept plastic. But you did open an equity credit line a couple of years ago when you were thinking about that bathroom renovation that you decided to put off. So the equity line can cover this instead. You discover that the interest rate just dropped to 7% – not a fantastic rate, but better than your credit card.
So where are you now? Your $250/month cushion is history. Until now, you’ve been paying off your credit card balances every month, but with $2,500 in extra charges, there’s no way that will happen this month. You’ve got a further $12,000 to pay off on your equity line. If you apply the $250 a month to paying off the two balances, it will take you more than a year to pay off your credit card and another five years to finish paying for the roof. Assuming your credit card interest rate is 16%, you’ll spend about $3,200 in interest. Most of that is from the HELOC, so you’ll get a little money back in an itemized deduction. Your net interest cost is about $2,800.
In order to avoid going further into debt, you must trade summer vacations for three years of “staycations” until your income has increased enough to allow you to start saving again.
Things would have been even worse if you hadn’t had the equity line to fall back on, or if your cash flow had been such that you were only able to make the minimum payments on your debts (bankrate.com has a nice calculator that shows the long-term cost of minimum payments).
How might this scenario have played out differently? Suppose that ten years ago you realized that you needed an emergency fund. You cut back your latte consumption from five to two a week. Twice a week you made your own lunches instead of buying food in the company cafeteria. This allowed you to save $75 a month to your emergency fund. On top of that, instead of spending your bonuses before you actually received them, you put half of every bonus into the emergency fund.
Consequently, when disaster struck, you’d have almost $15,000 set aside for emergencies. Despite going through three painful and expensive surprises, you’d still have a little bit left in your emergency fund at this point, and you’d have a good chance of building up a new cushion to protect against future surprises.
With an emergency fund, you can “ride out” events that can’t be anticipated. A job loss, an unexpected medical expense, or a “bad Freon week” can happen to anyone. Although one’s credit capacity can be a useful reserve, it should never constitute 100% of your backup plan for emergency expenses. If you have to use credit repeatedly to deal with emergencies, you can easily find yourself caught in a debt spiral that may be difficult to escape.
An emergency fund is rather like insurance – you hope you never need it, but if you need it and don’t have it, the consequences can be quite unpleasant. My job as a financial planner is to help clients plan for the things that they’d like to have happen, as well as for unexpected things that they’d rather avoid. Having an emergency fund is an important part of household risk management.
Image by: kennysarmy