Emergency Fund: The Key to Successful Personal Finance

An adequate emergency fund is the most important element of successful personal money management. Yet, it is often mischaracterized and its importance minimized by personal finance experts. An adequate emergency fund provides liquid cash to cover a temporary decrease or interruption in income from a reduction in hours, loss of job, or illness. As such, it provides a sound foundation for personal finances. Without it, budget accounts, targeted savings, and retirement savings are raided during periods of interrupted income. If the interruption lasts long enough to exhaust those savings accounts, debt is incurred to cover living expenses. In the absence of an adequate emergency fund, an interruption in income has the potential to wipe out years of financial progress. That is exactly what happened to many households during the Great Recession of 2007.

Emergency fund misunderstood and minimized by some financial experts

Those personal finance experts who minimize the importance of an adequate emergency fund do not understand the purpose of it. This is obvious from the advice they give. One of the most popular personal finance experts suggests funding emergency savings with only $1,000 before funneling all available money into debt elimination. He assumes that $1,000 will cover most household emergencies such as car repairs, appliance repair or replacement, house repairs, and medical co-pays and deductibles without having to use credit to pay for them. Another personal finance expert suggests funding emergency savings with only $500 before putting all available money into retirement saving and debt reduction. She estimates that amount will cover a car repair or other such expense that exceeds monthly income.

In the view of these personal finance experts, the purpose of an emergency fund is to pay for expenses that exceed monthly income. Those types of expenses are often called unexpected expenses, but they are no such thing. While no one knows exactly when a car repair or appliance repair or replacement will be needed, they do know that they will occur eventually. They are not unexpected, rather they are unpredictable. Unpredictable expenses should be handled through the budget with an amount set aside each month in anticipation of car repairs, appliance repair and replacement, insurance deductibles and co-pays, and house maintenance and repair. The balances in these accounts will grow until they are needed and represent a form of short-term savings. An emergency fund is separate from and in addition to budgeted savings for unpredictable expenses.

How much money does an emergency fund require?

What is an adequate emergency fund? Most experts refer to the average time it takes a person to secure full-time employment and suggest that the emergency fund have enough cash in it to cover basic living expenses for that period of time. The average time it takes to find a full-time job varies with the job market, but cash to cover three to six months of living expenses is often considered an adequate emergency fund. In the immediate aftermath of the Great Recession, many personal finance experts advocated for an emergency fund that covered one year of living expenses. You will have to determine what is an adequate emergency fund for you. In doing so, remember that you lose nothing by allocating too much money to an emergency fund. You can always reallocate some of it to other types of saving accounts or spend some it if you ever feel your emergency fund is excessive. It is better to have saved too much than to find out you saved too little when it comes time to deal with a reduction or interruption in income.

Three months to six months of living expenses represents a lot of money. For example, say a family requires $4,000 per month to cover essential living expenses (food, shelter, debt payments, insurance premiums, transportation, and such). An adequate emergency fund for them would require $24,000 in liquid, short-term savings, or about the price of a new mid-sized sedan automobile. It is tough to advise someone to defer the purchase of a new car or other spending in order to establish an adequate emergency fund. This is one reason some personal finance experts minimize the importance of an emergency fund; they know that most people would rather spend their money, pay down or pay off debt, and save for retirement than set aside cash for an emergency fund. Spending, debt, and retirement saving are issues that confront Americans daily. They worry about them. Most Americans are in denial of their vulnerability to a reduction or interruption of income; they do not perceive it to be an immediate problem.

Households need a stake

All enterprises, including households, need a stake, a cash reserve, over and above immediate income to bridge those times when income is insufficient to meet the budget. Businesses need operating capital. Individuals and families need an emergency fund. Accumulating it is really not that unrealistic if the need for an emergency fund is understood. Say the family in the earlier example above brings home $5,000 a month after tax withholding. The difference between their essential living expenses ($4,000) and take-home pay ($5,000) is money spent on entertainment, vacations, clothing, and similar non-essential expenses. At a 15% rate of saving ($750/month), their emergency fund ($24,000) would have adequate cash in 32 months, less than 3 years. They would have 3 months of living expenses in the emergency fund after only 16 months. Imagine, this family could enhance their financial security dramatically in a little over two and a half years and enjoy it over a lifetime, adding to it from time to time as their living expenses increase.

An emergency fund preserves the integrity of household finances

In the absence of an emergency fund, the only financial security is the next paycheck unless there is a retirement savings account to raid. But what is the point of accumulating retirement savings only to have the account drained to cover a temporary reduction or interruption of income?

Elimination of debt is a worthy financial goal, but there is something worse than being in debt and that is being broke, which is exactly the outcome for people who experience a temporary reduction or interruption in income if they do not have an adequate emergency fund and no retirement savings.

In its role of providing insurance against temporary reductions or interruptions in income, an adequate emergency fund preserves the integrity of household finances including retirement savings. As such, an adequate emergency fund is the key to accumulating the money needed to replace income in old age. It takes both short-term savings (emergency fund and budgeted savings) and long-term savings (retirement savings) to enjoy financial security over a lifetime.

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages

Parents Sacrifice Financial Security to Spend on Elite Youth Sports Programs

Many parents of children who participate in elite youth athletic programs put their family’s financial security in jeopardy in order to pay for youth sports. A recent survey by TD Ameritrade revealed that most parents of children in these elite athletic programs spend an average of $100 to $500 per child per month on youth sports while 20% spent over $1,000 per month per child. These levels of spending occur despite an absence of an emergency fund (40% of respondents) or retirement savings (33% of respondents). All respondents have children who are members of elite club teams sponsored by non-school organizations.

Loss of perspective

Encouraging youth athletic competition and spending money on it is admirable, but if basic financial needs are being ignored in favor of additional spending on youth athletics, there has been a loss of perspective. The survey revealed that 57% of respondents had no long-term financial plan. It is difficult to prioritize spending without long-term financial goals and a plan to attain them.

Those parents who expect to receive a financial return on the money they spend on elite youth athletics have also lost perspective. Two-thirds anticipate their children will win college athletic scholarships while only 24% received scholarships, and 34% expect their children will compete in the Olympics or professional athletics when in reality only 2% do so.

Early specialization and drawbacks to participation in elite youth athletics

High levels of competition in elite youth sports programs push youngsters to specialize in one sport at an early age. Eighty-three percent of respondents’ children participated in only one sport and played that sport competitively nine months out of the year. Specialization most often occurred between the ages of 9 and 10. This may be why “burnout” was identified by 49% as the number one drawback to their children’s participation in elite youth sports programs. “Time commitment” (49%) and “possible injury” (46%) came in as the second and third most cited drawbacks to participation in elite youth athletics.

Benefits of participation in elite youth sports programs

Survey respondents identified “teaching values” (67%), “increased confidence” (41%), and “regular exercise” (36%) as the top three benefits their children get out of participating in elite youth sports programs.

How to reduce the cost of participation in youth sports

The benefits of participation in organized youth sports are valuable. Here are some options for reducing the costs of participation:

  1. Buy used sports equipment. Young children outgrow athletic equipment before they wear it out.
  2. Avoid the cost and time commitment of elite programs until a later age. Instead, have your children participate in city recreation programs or programs sponsored by local service and civic organizations. These are available at a minimal cost, and your children will still receive the benefits of organized athletics noted above.
  3. Avoid early specialization, limit participation in any one sport to three or four months out of the year, and encourage participation in multiple sports. This will help prevent burnout, reduce the costs of repetitive use injuries, and broaden your children’s exposure to athletics.
  4. Parents do not have to jeopardize their family’s financial security in order for their children to participate in organized sports. The place to start is to identify long-term financial goals, make a plan to attain them, develop a budget that reflects the plan, then determine what can be spent on youth athletics without putting the financial plan at risk of failure.

    K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages

Are You Asking the Wrong Question?

Whenever you face a financial decision, what question do you ask yourself? If that question is, Can I afford this today?; you are asking the wrong question. The impact of financial decisions carries far beyond the moment they are made. A debt will affect you for the term of the loan. The decision to retire will affect you for the rest of your life. Even the purchase of a couch can have an impact on your finances for weeks or months into the future.

What is the right question to ask?

So what is the right question? It depends on the circumstances. The proper question for a 60-month car finance purchase is, Can I afford the monthly payment for the next five years? A decision to retire requires the question: Will I be able to afford to live on my retirement income and accumulated assets, taking inflation and increased health costs into account, for the next 20 to 30 years? The appropriate question for non-essential everyday expenditures such as eating out, going to the movies, or the purchase of a clothing accessory is, Can I afford this and still make my essential expenditures for the balance of the month, including any unanticipated expenses such as medical co-pays and repairs on vehicles or appliances?

You take change into consideration when you ask the right question

If you are honest, asking the right question forces you to think about the future. In thinking about the future, you must account for change, and not just any change; you must account for what might go wrong. How have circumstances changed in your life over the last year, three years, five years? Has your cost of living increased? Have you been laid off or had your hours cut? Have you experienced health problems that kept you from working? Have you experienced periods when there was a reduction or interruption of income? Have you had to pay medical deductibles and/or co-pays, auto insurance deductibles, auto repair expenses, appliance repair or replacement expenses, or repair expenses to your house?

Account for change in the future with savings

How do you account for what might go wrong in the future? You do it with savings. You need cash in reserve to handle expenses that exceed your monthly take-home pay and to cope with reductions or interruptions in income. If you don’t have savings, your answer to the purchase question is always “no”; you cannot afford to purchase anything that is not an essential expense such as food, rent, utilities, fuel, insurance, maintenance drugs, and any payments on debt. If you don’t have at least three to six months of living expense in an emergency fund to replace reduced or lost income, the answer to the purchase question is “no”; you cannot afford to purchase anything that is not an essential expense.

At a minimum, you need enough short-term savings to cover insurance deductibles and out-of-pocket expenses, a major repair to the automobile, and the replacement of a major appliance along with a separate emergency fund equal to three to six months of living expenses. Without this short-term cash on hand, you cannot account for the future, and therefore, cannot afford to purchase other than essentials.

Retirement requires accounting for change over a 20 to 30-year period of time. How do you know how inflation will affect your cost of living over two to three decades? Can you accurately predict your state of health and the costs of health care during that period of time? The truth is you can only make intelligent guesses about the future. The answer to dealing with an unpredictable future is to have a hefty cushion of retirement savings and let it grow, untouched, during the first decade of retirement. You can do this if you live on less than your retirement income during the early years of retirement.

What about the good things that could happen in the future?

Does accounting for what can go wrong in the future sound negative and pessimistic? What about the good things that can happen: a raise, a better paying job, or a bonus? True, the future may hold good fortune for you. The thing is, you cannot count on it. If you want to get out of debt and stay out of debt, it is absolutely necessary to account for what could go wrong in the future. If you don’t ask the right question and fail to account for the future, the future will not be kind to your finances, and you will be forced to take on debt to deal with unfavorable changes. On the other hand, when you ask the right question and account for the future, our experience has been, more often than not, that the future turns out to be bright.

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages