Welcome to 7th Street Financials series of original content on financial planning. The goal of this series will be to help educate you on a wide number of topics related to your financial wellbeing. Last week I kicked off the series with an article on the personal finance pyramid which can be seen here. Today I continue with a deeper dive into the base of the financial pyramid, specifically emergency cash reserves.
You have maybe heard before that you should have 6 months of expenses in a savings account. Why do you need this and what does it mean for you?
According to this article using data from a Federal Reserve salary the mean savings account balance for Americans is $5,200 while the average is over $33,000. The mean represents the number where there are the same number of accounts with a balance lower than that amount as well as higher than that amount. For instance if you took 100 people and sorted in order of numerical value it would be the 50th largest account. The average account is skewed higher by a number of accounts with significantly higher balances. Even more alarming, according to this Bankrate survey only 39% of Americans can cover a $1000 emergency with their savings.
Let’s start with understanding what qualifies as emergency savings. This is basically cash or cash equivalents you have quick access to. This is your savings account, money market funds or anything else that can be cash in your hands within a day or two. People will debate whether a CD counts as it is held at your bank as a savings vehicle but has a maturity time frame and there is generally a penalty for cashing in before the maturity date. Generally, it is best to meet the savings requirement without counting CDs. Cash in retirement plans does not count either as there is a penalty and tax consequences to accessing these funds.
Now, why do you need it? Emergency savings are needed to cover those unexpected items that come up. Examples are items like car and house repairs or medical bills. These types of expenses can run several hundreds or thousands of dollars and can be tough to be absorbed by regular monthly income. Without having cash savings on hand you are forced to put these expensive charges on a credit card racking up interest and no real game plan for how to pay off the debt other than slowly chipping away at them every month. But, if cash is available you can simply just use it to pay the bill and move on.
The potential of someone losing a job is another major factor for compiling emergency savings. In the event this happens to you there has to be funds available to pay the bills. You may or may not get a severance package or unemployment benefits depending on the circumstances of separation from employment and those funds may not cover your monthly expenses or last very long.
How much emergency savings do you really need? Do you really need six months on hand? It depends on your circumstances and how dependent you are on one of the salaries. The more dependent you are on one salary the more important it is to strive to hit the six month mark. That is because the loss of that salary represents the loss of the bulk of your income and it might take time to find suitable employment again. If there are two roughly even salaries in the household, you can get by with closer to three months because if one salary is gone you are still probably able to cover half of the expenses with the remaining salary. In this case having three full months of expenses is equal to having six months of half the expenses so it is reasonable to not have as high of a target.
Emergency savings are possibly the number one priority for a household to target in terms of forming a sound financial base. That does not mean, however, that you should just focus on building up six months of reserves while ignoring other financial priorities. You should still be contributing to your workplace retirement plan but maybe not maxing it out in lieu of building up savings. Contribute enough to get the full employer match and make sure you are paying your debt obligations. The best and easiest way to achieve this is goal is to make automatic payroll deductions that are deposited into your savings account in the amount you have determined is reasonable and will help you get to your goal. Trying to get to the end of the month and moving excess funds in reality just doesn’t work. People have the tendency to spend what they can but will find a way to get by if it’s not there to spend in the first place.
Lastly, now that you know to make savings a priority, where do you put it? We have talked about this as a traditional savings account but right now traditional savings accounts are earning very low interest rates. These rates are starting to come up so check with your bank to see what they are offering. Another option is to look at a well known internet bank such as Ally or Marcus by Goldman Sachs amongst others. These online banks are offering interest rates of 1.5% or higher which might be a lot more than you get at your bank. It might not be as easy to get your funds out of these as they don’t have traditional branches and their ATM network might be limited but they do allow online transfers into your regular bank account so determine your requirements for how quickly you need to access the funds against the interest rate you can earn.
Take the opportunity to review your situation and make sure that you can handle the unexpected expenses that life can throw at you. Make this a priority if you haven’t yet. It will save you from sleepless nights when life throws you a curveball.
Thank you for reading and stay tuned for the next installment of the Financial Planning 101 series which will focus on debt management.