Cash In A Crunch - emergency fund as savings priority

Kiplinger's Personal Finance Magazine, Feb, 2001 by Catherine Siskos

STARTING OUT Building an EMERGENCY FUND should be your top savings priority.

BRIAN MACKIN'S 1994 Ford Bronco died abruptly One day last July. Then he got the really bad news: It would cost $3,000 to resuscitate the truck. With no savings and nothing close to three grand in his checking account, Mackin, 24, was forced to abandon the Bronco in his driveway until he could afford the repairs.

Deprived of his wheels, he hitched rides with family members and friends to get to work, and even called a cab a few times. "I could have set emergency money aside in a savings account, but I just wasn't thinking ahead," admits Mackin, who works as an administrative assistant for, of all places, a financial-planning firm.

After three months of brown-bagging lunch and sacrificing his social life, Mackin had scraped together $2,100. His dad took pity on him and pitched in the rest of the money. And Mackin decided to work out a financial fix, too. Instead of moving out of his father's home in Centreville, Va., to get a place of his own as he'd planned, he's taking extra time to pour money into a rainy-day fund.

Standard financial wisdom is to save enough cash to cover three to six months of living expenses--such as rent, food and utilities--in case you lose your job or, like Mackin, are unexpectedly hit with a large bill. But only 38% of Americans actually keep that much savings on hand, according to a survey by Lutheran Brotherhood, a financial organization sponsored by the Lutheran Church. Young adults are especially short of cash, with just 30% of them reporting they have a cushion that would last at least three months.

It's not that young adults don't save. Because they have doubts about the future of social security, Generation X (adults between the ages of 24 and 35) has started saving for retirement earlier than previous generations. "But they don't take emergency funds seriously," says Nathan Dungan of Lutheran Brotherhood. One reason for the lack of motivation, Dungan believes, is the strong economy. Dotcoms may be laying people off in droves, but "when was the last time you heard someone say they had spent eight months without a job?" he says.

Credit cards and retirement accounts share the blame because both divert cash from emergency savings and create a false sense of security. "Young adults will tell you that their credit card or their 401(k) plan is their emergency fund," says Patti Houlihan, a financial planner in Oakton, Va.

But financing a calamity with a credit card that charges 19% or 20% interest only creates a vicious cycle of more debt and little savings. It's equally risky to borrow from your 401(k). If you lose or leave your job before you've repaid the money, the loan is considered a distribution. "By the time you pay the taxes and the 10% penalty, you're lucky if you get 50 cents on the dollar," says Houlihan.

Savings shortcut. Nevertheless, the prospect of stockpiling enough cash to cover three to six months' worth of living expenses can deter even the most dedicated saver. "If your income is low and you have a lot of debt, a big cushion may not be feasible," concedes Marianne Shine, a financial planner in Deerfield Beach, Fla.

The solution is to aim for a less-daunting alternative, say a month's worth of expenses. As your income rises, beef up your cash reserve to cover longer periods and to reflect any increases in your spending, such as higher rent. Your rainy-day fund should also cover the deductibles for your health and car insurance, says Shine.

A cash reserve should be your first saving priority, even if it means delaying contributions to a 401(k). If you have credit card debt, consolidate it at the lowest possible interest rate, stop using the card, and make the minimum monthly payment so that you can use your available cash to build up the equivalent of one month's living expenses. After that, allocate savings toward other goals, such as paying down that debt or opening a retirement account, while you continue to build your cash reserve.

Mackin now sets aside between $250 and $300 each month, and expects to have $3,000 to $5,000 in an emergency fund within a year. With that task under his belt, he hopes to tackle his next big savings goal: enough cash to buy a new car.

Parking your cash. Once you have the money, keep it where you can get your hands on it. That means steering clear of the stock market. "You don't want an emergency situation to dictate when you sell shares," says Nancy Dunnan, author of How to Invest $50-$5,000. Even a bank certificate of deposit, which locks up money for a set period, is too restrictive, because you'll forfeit any interest earned if you withdraw the money early.

That leaves you with two options for parking your emergency cash: a savings account at a bank or credit union, or a money-market mutual fund. Banks sometimes offer free checking as a perk with their savings accounts, but they typically pay a meager rate of interest, currently about 2.1%. Credit unions generally offer a better deal.