The importance of an emergency fund

Most of us are creatures of habit. We find a certain comfort and safety in the predictability of our day-to-day lives. Unfortunately, that also means we tend to avoid thinking about or planning for unexpected and unwelcome changes. But change—sometimes drastic in nature—is inevitable from time to time. Whether it’s the sudden loss of a job, a precipitous market drop that impacts a portfolio’s ability to generate needed income, or an unplanned but necessary major expenditure, life without a financial “safety net” in the form of an emergency fund is a risky proposition.

Now, more than ever, it’s critical that one sets aside a formal emergency fund for unexpected expenses and/or a reduction in income. Without this safety net, one could find a situation of having to run up high-interest credit card debt, drawing down the home equity which took years to build, or needing to sell long-term assets (at a time when both the economy and the stock market are slumping).

Creating a safety net

Ideally, one should set aside enough emergency cash (typically held in a liquid checking, savings, or money market account) to cover at least six months of living expenses. For small business owners or those employed in highly volatile industries and sectors, a 12-month cushion may be more advisable.

As with any goal, the more time available to build the safety net, the easier the task is to accomplish. The simplest way to get started is to just begin setting aside a fixed amount each month into a separate emergency fund account. To help speed up the process, one might want to also consider depositing all or a portion of each year’s tax refund and employment bonus into this account. Because these represent money that falls outside of the normal monthly budget, it’s often much easier to save these windfalls without feeling deprived.

Alternatively, if one owns a whole life or universal life insurance policy, they may be able to tap into its built-up cash value as a source of funds in an emergency.  A policy’s cash value is the amount of money received by surrendering the policy, and functions like an investment account that accumulates tax-deferred interest.  Unlike a bank loan, the owner does not have to pay back a loan against cash value and withdrawals are tax-free up to the amount of the premiums paid.  However, it’s important to understand that interest charged borrowing against a policy’s cash value will gradually reduce the death benefit loved ones will receive.

Lastly, if emergency funds are needed before there is enough time to build an adequate safety net, one may want to consider contacting the mortgage provider and establishing a home equity line of credit.  These funds should only be accessed in the event of a true financial emergency and not for day-to-day expenses.

Don’t wait until it’s too late

Preparing for emergencies is a critical part of a thoughtful and comprehensive financial plan. By having sufficient funds set aside for immediate but unexpected cash needs, one will be in a much better position to weather short-term economic turbulence and market volatility while remaining on track toward long-term goals and objectives.