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.
A diversified portfolio can actually help you manage cash flow in an emergency.
Don't raid your retirement fund to pay the bills unless absolutely necessary!
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 2015, 47 percent of respondents said they wouldn't be able to cover a $400 emergency expense or would have to borrow or sell something to come up with the money. That's a pretty scary statistic.
So I ask you, could you come up with $400, or $1,000, or $2,000 to tide you over in the face of a financial emergency? If the answer is no, or you're not sure—or even if you're pretty confident that you could—I hope you'll take a few minutes to read on for some practical tips on how to prepare yourself for just such an emergency. To me, it's just part of good financial planning.
Five ways to prepare for a financial emergency
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 essential expenses; ideally you should aim for six months. Keep this money in something liquid like a savings account.
It may sound like a lot all at once, but you can build it up slowly. Designate a specific account as your emergency fund and make deposits to it a part of your monthly budget. Make it easier by setting up automatic payments to this account. Then commit to not touching this money unless there's a real financial emergency.
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.
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 when you need to rely on credit for a short period of time, you'll have it. This includes paying your bills on time as well as keeping a low ratio of available credit to credit used, which really means keeping your credit card balances low.
Also, if you own your home, consider establishing a home equity line of credit. A HELOC gives you an additional cash resource, and you only pay interest on the money you use. Of course, you have to pay it back, but the payment schedule is generally over a 10-year period. Hopefully, that would give you enough time to recover financially.
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.
Consider personal liability insurance to protect your assets should a third party file a claim against you. It's often part of automobile or homeowners insurance, but a separate umbrella policy is also available at reasonable cost. If you're in your prime working years, you may want to look into disability insurance. Long-term care insurance is also worth exploring.
Keep your investments diversified—While your portfolio can be a source of funds when you need it, there's no way to predict where the market will be when you're hit with an emergency. So to help protect yourself from having to sell at a loss, make sure your investments are well diversified. A combination of stocks, bonds and cash investments will give you the most flexibility should you have to sell before you planned.
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, 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 doing this yourself rather than falling victim to a potentially costly debt management or consolidation scheme.
Finally, even if it's possible to borrow from your 401(k) or take a hardship 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.
October is financial planning month, so I encourage you to take this time to review your financial situation and make sure you're as well prepared as possible for the unexpected. It only makes good sense because financial emergencies can happen to anyone—even to you.