Why Start an Emergency Fund?

A man with a crazy gray wig and red glasses yelling representing the life of the party

There is nothing less sexy in personal finance than the emergency fund.

Yes, I realize that contemplating death while diving into a life insurance policy is no fun either, but I’ll save that for another day. While the emergency fund may not be the overindulgent life of the party, it is definitely the dependable friend who will get you home and safely into bed.

The hierarchy of savings is a popular topic in personal finance. Search for the phrase in Google, and you’ll see what I mean. I like to think of an emergency fund as the foundation of the saving’s pyramid. It should be the first place you save money. Yes, even before you jump on Robinhood to start trading options.

Michael Kitces included a fantastic version of the pyramid you can find in his article – “The Hierarchy Of Tax-Preferenced Savings Vehicles For High-Income Earners.” It appears below.

A colorful pyramid illustrating the hierarchy of savings

How much should I save?

The most common recommendation is to save enough to cover 3 to 6 months of expenses. Solid advice. But how do you know which number is right for you? Ask yourself the following questions.

  • How many sources of income does my family or I have?
  • How stable is my job?
  • How quickly would I be able to get another job?
  • Do I have substantial investments that are reasonably liquid outside of my emergency fund?
  • What percentage of my monthly spending is discretionary, and can it be cut in an emergency?

It can be difficult to answer some of these questions accurately but err on the side of adding an extra month or two in savings if you’re in doubt.

What makes an emergency fund so important?

There’s no better way to derail your retirement plans than to pile on some high-interest debt because you lost your job. Your emergency fund is there to provide funds when life throws an unfortunate surprise at you. 

A brown shoe about to step on a banana peel

An emergency fund also gives you options. Panic over a lost job, a medical emergency, or a car accident can result in rushed, poor decision making. If you find yourself unemployed, would you rather calmly look for a new position that fits your career goals with a company you admire or grab the first job that comes along because you’re desperate for income?

Do I have to worry about this? I make some serious coin!

Given the importance of establishing an emergency fund, it’s sad to see only 28% of people in the U.S. have savings equal to six months of expenses, according to the Federal Reserve. And before you dismiss this as a problem for Generation Z, the same survey shows that only 39% of people over 55 have savings to cover six months. But high-income earners are rock-sold, no? Not really. Only 54% of earners in the top quartile could cover expenses for half a year using emergency savings.  

What’s even worse? This survey was completed well before COVID-19. I’ll take a wild guess that savings levels are even lower now for many Americans.

Even with a high income and substantial retirement savings, an emergency fund is a good idea. Retirement savings are great – for retirement. If you have to access retirement accounts in an emergency, there may be penalties, taxes, and fees. You will also miss out on the growth those investments would have delivered, potentially setting back your retirement goals.

When should I access my emergency fund?

Uh, in an emergency? True, but try to define what this means beforehand. An emergency should be a serious, unexpected financial event that must be addressed. Medical bills, car repair, a job loss are all reasons to tap your fund.

A toy ambulance

I work with travelers, and I know the pandemic lockdown has been difficult. You might believe that a trip to Paris after you’ve received a COVID-19 vaccine is an emergency of mental health. But, no, while possibly an emergency, it’s not a good reason to tap your fund.

How to build it?

Put your emergency savings into a separate account. Setting up an automatic withdrawal from either your paycheck or a checking account is the best way to fund it. I emphasize automatic, so it happens without effort on your part. It may take time to meet your emergency fund goal, but religiously making a deposit on a set schedule works well.

Where should I put it?

Liquidity is the key. Emergency money should be saved in a place that can be accessed quickly. A high-yield savings account or a money market account is ideal, and both are insured by the FDIC up to $250,000. Don’t get cute and reach for a higher yield by putting your emergency fund into an investment product that might lose value, is not insured, or is not readily available when you need it. Also, there are many financial institutions that are competing for your business, so look for accounts that will not charge you a fee of any kind. Bankrate is an excellent resource to find the best yielding money market accounts.

How else will an emergency fund benefit me?

An exciting part of having an emergency fund, yes, I said exciting, is it gives you financial flexibility. You can use this flexibility to save some serious money. How, you ask?

Do you have a low deductible on your auto or home insurance? An emergency fund can allow you to raise the deductible and save money over the long term, assuming you’re not accident-prone.

A common question asked by travelers – Do I need travel insurance during COVID? The answer may be no if you have a hefty emergency fund, and your only possible loss is financial, measurable, and manageable.

If the possible loss can be strictly defined and equal to 10% of your emergency fund or less, I’d recommend passing on the insurance. On average, you will come out ahead financially in the long run. However, if you have a history of making claims, you have a habit of losing things, or you can’t sleep thinking about being uninsured, then buying travel insurance is a good idea.

If you do need to access your emergency fund, replenish it as soon as you can. It won’t help you much if you drained it last year and forgot to fill it back up.

Summary

Fully funding a liquid account that is to be used only for emergencies is an essential first step in financial planning. The account can reduce stress, present you with options, and save you money. Unforeseen events will happen in your life, and it’s always better to be operating from a position of financial strength and security than having to scramble around to see which long-lost relative will float you a loan. Get this foundation of financial savings right, and you’ll be on your way to retirement glory.


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    Financial Advisor David Tuzzolino

     

    David Tuzzolino, CFA, CFP®, is the Founder and CEO of PathBridge Financial, a firm that specializes in providing comprehensive financial planning and investment management services for clients that are nearing retirement and love to travel.

    I’m a Financial Advisor and I Love Credit Cards!

    Why It Makes Sense to Use Credit Cards Wisely

    The poor, lowly credit card. Demonized by money gurus everywhere. Is it possible that credit cards aren’t nearly as bad as they are made out to be?

    I’m a financial advisor, and I love credit cards! Yes, I said it. They can be a great tool if used wisely. They can also be a nightmare if used improperly, but that can be said about most financial instruments.

    Let’s jump into the benefits:

    No ATM Fees

    The average withdrawal from an ATM in the U.S., according to the Federal Reserve Bank of Boston, is $103, and the average ATM withdrawal fee in 2019 was $4.72 per Bankrate.com. That’s a 4.6% tax on consumers every time they access their hard-earned money. If you need a cash withdrawal, try to use an ATM that is affiliated with your bank, sometimes easier said than done when you need cash right away. Or, better yet, open an account that refunds any fees charged for using a third-party money machine.

    Admittedly, credit cards come with their own set of fees/interest charges to avoid. However, this shouldn’t be difficult to do as long as you research the right card for you and are diligent in paying it off each month.

    Stolen or Lost

    Have you ever been robbed at gunpoint? I have! It’s loads of fun (sarcasm). Shortly after college, while getting into my car after the evening shift at a local department store, I had a gun pushed into my ribs. The only thing I could think of immediately after the incident – “That was a very big gun!”

    I had cash and credit cards in my wallet that night — the cash, gone forever. The credit cards, I quickly canceled them. Actually, I got the cash back because the robber was later caught, but that kind of ruins the moral of the story. If you’re ever robbed, you’re likely never going to see your cash again.

    A funny side note is this robbery almost resulted in me being in the middle of an all-out, courtroom brawl. However, I’ll save that story for another day.

    Almost everyone has lost money at some point in their lives. The wallet that fell out of your pocket, the purse you left on a table. The money you blew on the ponies…actually, that’s a different type of loss outside the scope of this article.

    Would you rather lose cash or credit cards? Credit cards can be canceled and replaced; cash cannot.

    Credit Score

    Credit cards can help you increase your credit score as long as payments are made on a timely basis. Our good friend, the FICO score, is used by institutions who would like to extend you credit. 35% of the FICO score is based on your payment history. Pay off your credit card on time, and your FICO score goes up.

    A high FICO score will make it more likely financial institutions will give you a loan. It can also lower the interest rate you are offered. Even most people who avoid debt like the plague have a mortgage or car loan at some point in their lives. The savings can be substantial if you can get a lower interest rate on these loans.  

    Emergencies

    Oceanfront View in Cabo
    Four Seasons Resort Los Cabos at Costa Palmas

    Credit cards can be a comfort when real emergencies occur. What is not a real emergency? – “I’m having a nervous breakdown at work and a week-long vacation in an Ocean Front Executive Suite at the Four Seasons Cabo sounds good.” Nothing against this type of spending if you can fit it into your budget. It actually looks quite lovely! However, if you’re going to have to run a balance on your credit card, it’s not a good idea.

    To clarify further:

    Emergency: Your car was sideswiped by a Tesla driver who fell asleep at the wheel while autonomously driving down the highway, and you have to cover the deductible on your vehicle in order to drive to work to support your three kids.

    Not an Emergency: You will look “tasty” in a new, apple-red convertible.

    If you establish an emergency fund early in your career, hopefully, an emergency charge to your credit card is never needed. It’s a nice fallback, however, in times of great need. A thirty-day reprieve while waiting on a paycheck might be precisely what you need. You should still do whatever you can to pay off the entire balance each month to avoid paying interest.

    Rewards

    Now it gets good. What type of rewards make the most sense in your life? Does cashback sound good? How about airline miles? Do you dine out frequently? Where do you spend the majority of your money? Make sure your credit card is best suited for the type of rewards you want to receive by doing research at sites such as nerdwallet or The Points Guy.

    Many cards have no annual fee. For those that do have a yearly fee, make sure the rewards are good enough to cover it. Many credit card companies will waive the first year’s annual fee, so keep in mind you will automatically be charged in the future.

    Credit card reward programs are constantly changing, so please double-check the specifics of the cards mentioned below. Some of the credit cards I hold:

    The Discover Card offers unlimited 1% cashback on your purchases. 1% isn’t a tremendous reward, but they also offer 5% cashback on specific categories that change every quarter. In the last three months of this year, the 5% cashback applies when making purchases at Amazon.com, Target.com, and Walmart.com. Do you think you’ll be doing some holiday shopping with any of these companies? Yes, that’s what I thought. The best thing about the Discover Card, there’s no annual fee.

    The United Explorer MileagePlus card has a yearly fee of $95. But it makes a lot of sense in my wallet. I love to travel, and this card has some nice perks. There’s a generous sign-up bonus of 40,000 miles, which can be leveraged into a couple of free domestic flights. You will also receive one mile per dollar spent and two miles when using the card for dining, hotels, or with United Airlines.

    There are additional perks as well, including a reimbursement for money spent on TSA-Precheck and priority boarding. You can relax in a United Club twice a year, which is a great place to load up on food and drink before boarding a plane where you’re lucky to have a bag of peanuts thrown at you. And then there’s my favorite perk of all, a waiver of the checked-bag fee.

    A little about me and the checked-bag fee. There are few things in this world I hate more than paying to check a bag. I will do nearly anything I can to avoid paying it, including wearing an entire suitcase full of clothing to the point where I am so layered I look like Joey in the episode of Friends where he puts on all of Chandler’s clothing

    I fly on non-business trips at least six times a year. Most airlines charge approximately $30 per flight-leg for the privilege of chucking your bag into the underside of the airplane. I am always flying out of Pittsburgh, and, unfortunately, most trips involve at least one layover. That is six trips a year, times four flight legs per trip (I have to return home), times $30 = $720 in checked bag fees I can avoid paying. And if you’re flying with a companion, their first bag is free as well, so double that savings!

    As I mentioned earlier, do your research and find the credit card that makes the most sense for you. If a card has an annual fee, make sure the benefits you receive outweigh this charge. Also, try not to fall into the trap of opening up new accounts each year and piling up a wallet-full of credit cards you never use. Close accounts if you’ve stopped using them.

    No Change!

    This point may seem silly when compared to the other benefits in this article, but I can’t imagine going back to using cash all of the time and walking around with a pocket full of change. I cringe thinking of the $19.03 purchase where I hand the cashier a crisp, new $20 bill only to receive a handful of coins. And don’t get me started on pennies!

    There’s also the random container in the back of your closet where you dump your change. It could be an old Tupperware container, a shoebox, or your 1980’s-era, “I Shot J.R.” mug. I Shot J.R. MugRegardless of the receptacle, it will become full one day, and to empty it, you’ll have to cart it off to a bank or find a Coinstar kiosk. Then this evil cycle begins again.

    Can you tell I have a personal beef with coins? A credit card can put a stop to this never-ending cycle.

    People Who Use Credit Cards Spend More Than People Who Use Cash

    Some studies show consumers spend more money when using credit cards as compared to using cash. Two factors seem to drive this behavior: pain and convenience. Pain is associated with handing over paper money; it hurts a little bit. On the other end of the spectrum is the simplicity of using a credit card. It’s convenient and causes little pain.

    A quick swipe of a credit card and you’re out the door. It’s almost like it wasn’t real money. No counting out bills and watching the cashier pull them from your greasy, little hands. The ease of this transaction will lead you to the poor house, right? Better get used to it.

    You know what is more convenient than swiping a credit card? Clicking a mouse or waving your iPhone in front of a scanner, and it’s the future. Like it or not, transactions are moving online. It’s only getting easier to spend money. The crutch of using cash to make transactions less convenient and more painful is just not practical.

    So, unless you can program a virtual hand to reach out from your computer or smartphone and slap you upside the head every time you hit the Amazon 1-Click button, you’re going to have to get used to a digital world of transactions with no pain. But there may be a solution.

    Want to feel some pain to curb spending? Start a budget. A nice benefit of using credit cards is most of your spending is recorded in one place.

    At the end of the month, sit down with your credit card statement and go through your spending. Put a picture of your child, spouse, or other loved one nearby where you can see it clearly.

    Did you spend more than your budget allows while stocking your wine cellar instead of funding your daughter’s college savings plan? Take a look at the picture. This is the person you let down, who depends on you to save for their future. Feel pain? Something unpleasant is happening, because studies say you will save more for the future if you do this.

    If you make the switch from using cash to credit cards, monitor the change in your spending. Has it climbed dramatically? Are you finding it difficult to pay off every month? If so, you may not have the right mentality to use credit cards wisely.

    Summary

    Credit cards can be an excellent financial tool if used properly, and the benefits over cash are numerous. In today’s digital world, it has become simple to spend money conveniently and without pain. Strictly using cash to force fiscal discipline is impractical. A better way to attack responsible spending is by putting together a budget and sticking to it. Best of all, if you play your cards right (pun intended), you won’t have to pay those soul-sucking baggage fees!


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    Financial Advisor David Tuzzolino

     

    David Tuzzolino, CFA, CFP®, is the Founder and CEO of PathBridge Financial, a firm that specializes in providing comprehensive financial planning and investment management services for clients that are nearing retirement and love to travel.