Most American families are living paycheck to paycheck. This really comes to light when Federal workers miss a few pay periods during a government shutdown. In fact, a Federal Reserve survey found almost half of Americans wouldn’t be able to cover an emergency of $400.
Why do financial advisors insist clients establish an emergency fund? After all, the cash that is sitting in a low-interest checking or savings account is lagging behind inflation. You may be thinking that cash can be put to better use by paying down debts or invested in a brokerage account.
Regardless of how good your financial plan is, the steady progress you’ve made over the years can come to a halt in bad times. A financial emergency is just that -- an emergency. The bills are high and need to be paid promptly. If the payments are put off, the high interest rates start to snowball. This leaves you in a hole that is difficult to dig out of.
A recent St. Louis Fed study revealed just how important a cash buffer is. In general, they found that having more liquid assets and fewer debts reduced the chances of financial hardship. That makes sense. However, I found it interesting that having cash on hand was the greatest predictor of success.
Emily Gallagher and Jorge Sabat, authors of the report, stated it this way: “Our findings suggest that households should be encouraged to maintain at least a small buffer of liquid savings, even if the cash in that buffer is not being used to pay down high-interest debt.”
Having an emergency fund was found to reduce the frequency of rent/mortgage delinquency, regular bill delinquency, skipped medical care and food hardship. A cash buffer needs to be established before taking on other financial goals.
Some of the most critical expenses you have can’t be put on a credit card. The rent, mortgage payment, and utility bills must be paid on time and from your checking account. Living without a small cash buffer puts these necessary payments at risk in the event of an income shortage.
Need to boost your cash buffer? In today’s gig economy world, the opportunities to earn extra cash are almost endless. Look for ways to use your free time to make a profit. This could be by driving for a ride-sharing company, renting out a spare bedroom, or selling your unused clothes on eBay, just to name a few.
If you don’t currently have a cash buffer, your initial target should be $1,000 in a separate savings account. This amount will generally cover most of your deductibles, if you need to make an insurance claim. After you reach the $1,000 level, turn your focus to paying down the high-interest debts.
As high-interest debts get paid off, you want to establish what I consider a full emergency fund. This amount varies due to your personal circumstances, but generally lands between three to six months of expenses. Entrepreneurs, retirees, or others in sensitive financial positions should consider a larger emergency fund in the range of one to two years of expenses. Sound excessive? Remember that a cash buffer may be your most prized asset in times of trouble.