40 percent of Americans are not prepared to pay for a $400 emergency expense.
Having an emergency fund is only the first step in preparing for an unexpected financial need. Managing debt and having the right insurance are equally important.
Keep your emergency fund and other short-term money safe in a checking, savings, or money market account.
Watch the video: Ask Carrie: How Do I Prepare Financially for an Emergency?
What would happen if you were hit with an unexpected medical bill, a layoff, or your adult son or daughter needed a quick loan to get out of a financial jam? According to the Federal Reserve’s Report on the Economic Well-Being of U.S. Households in 2017, 40 percent of respondents said they wouldn't be able to cover a $400 emergency expense. Nearly 80 percent of American workers say they live paycheck to paycheck.
To draw attention and support for the millions of Americans who find themselves in a similar precarious financial situation, the consumer organization America Saves has declared February 25 to March 2, 2019, America Saves Week. As a financial professional I fully support their efforts, and would like to take this opportunity to offer some practical advice to you—or to anyone you know who is facing a savings shortfall.
Five ways to prepare for a financial emergency
1. Build up a cash reserve. I'm sure you've heard it before, but have you done it? To protect yourself, you really should have enough cash available to cover a minimum of three months of essential expenses; for some people, six months is even better.
It may sound like a lot all at once, but you can build it up slowly. Your goal is to spend less than you earn, and make monthly deposits to your emergency fund a part of your budget. Make it even more of a sure thing by setting up automatic payments to this account. Then commit to not touching this money unless there's a real financial emergency.
2. Reduce your consumer debt. Do this now before an emergency strikes so you won't be faced with missing any payments. By this I mean debt such as credit card balances. Focus on bringing those down to zero—and keeping them that way—while you conscientiously keep paying your mortgage, student loans, or car payments.
3. Have credit available. While this may sound like the opposite of point #2, it's really not. It actually has more to do with keeping a good credit rating so that if you need to rely on credit for a short period of time, you'll have it available. This includes paying your bills on time as well as keeping your credit card balances low.
If you own your home, consider establishing a home equity line of credit. A HELOC can provide an additional cash resource to back up your emergency savings. You only pay interest on the money you use. Of course, you have to pay it back, but the payment schedule and interest rate may be more favorable than using a credit card. To be clear, though, borrowing against your home is effectively a second mortgage and can increase your risk if not used wisely. It’s not a substitute for an emergency savings account.
4. Have adequate insurance. Health insurance is an absolute must, as well as automobile and homeowners insurance if you own a vehicle and your home. But don't forget to plan for deductibles and maximum out-of-pocket expenses. These can be significant (depending on your policy and your health) and factor into how much you should have in emergency savings.
Once you have the basics covered, you should also consider personal liability insurance, disability insurance, and long-term care insurance. This sounds like a lot of insurance (and a lot of additional expense), but sound insurance planning can help you avoid a financial catastrophe and ultimately reduce the size of the emergency savings you may need.
5. Keep your short-term money safe. Any money that you believe you might need in the next three years should not be in the stock market. Good choices for your emergency fund (and other money that you may need soon) are checking, savings, and money market accounts, and possibly short-term bonds or CDs in the mix. The bottom line is that cash or cash equivalents may not earn much over the long term, but they will give you the most flexibility and protection from a loss in the short term.
What to do if you find yourself in a financial jam
Even the best-laid plans can be upended by an unexpected crisis. If you find yourself struggling financially, here are a few things you can do to help ease your burden until things get better.
First, carefully examine your expenses and reprioritize your spending. Cut out everything but the essentials—things like mortgage or rent, food, utilities, and insurance. Pay the minimum on outstanding credit or loan balances. If you're unable to pay a bill, contact your creditors right away. They may be willing to negotiate a payment schedule or waive late fees. I'd suggest trying to do this yourself before signing up for a debt management or consolidation scheme. Some of these programs may overpromise and under-deliver and force you to incur additional costs.
Finally, even if it's possible to borrow from your 401(k) or take a distribution from your IRA, I'd consider this a last resort. While present circumstances may be difficult, I'd counsel anyone to avoid jeopardizing their future retirement unless absolutely necessary. You may not appreciate the full costs until much later.
There is no time like the present to get started. You can start small, but be consistent. With focus and determination, you can protect yourself from the unexpected. It only makes good sense because financial emergencies can happen to anyone—even to you.
Have a personal finance question? Email us at firstname.lastname@example.org. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.