Henssler Financial recommends that individuals retain a certain amount of liquid assets, at all times, to handle emergencies. This is known as an emergency fund or emergency cash reserves. These assets should be kept liquid and not invested to any sort of growth investment such as stocks or mutual funds.
What is an emergency fund?
As stated above, an emergency fund is an amount of liquid assets that can be used to handle emergencies, should they arise. The fund should be sufficient to handle emergencies so that an individual will not have to borrow money or liquidate investments at an inopportune time. An emergency fund should exclude the expense of income related taxes and contributions to investments or savings. Usually, emergency funds are set aside to cover expenses that arise from an individual’s short-term loss of income because of unemployment, disability, or death of a breadwinner. Emergency funds also can be used to cover unexpected expenses—a new roof for the house, a new transmission for the car, or any other unexpected expense.
In general, a person should maintain the equivalent of three to six months of fixed and variable expenses (excluding income related taxes as well as savings or investments). This guideline is derived from the point of view that if an individual were to lose his or her income because of the loss of a job, the individual will not earn an income and therefore will not pay income taxes. Furthermore, if there is no income, the individual will not be saving or investing.
What investments are appropriate for an emergency fund?
The most appropriate vehicles for an emergency fund are cash and/or cash equivalents, such as checking accounts, savings accounts and money market funds. These assets are low risk and can be readily converted to cash. Short-term certificates of deposits (CDs) are also appropriate vehicles for an emergency fund. We recommend that CDs used for an emergency fund have a maturity date of 90 days or less, and that a portion of the emergency fund be kept in something more liquid that can be accessed immediately with no penalties.
Life insurance cash values can be used as a vehicle for an emergency fund as well. However, these policies may contain delay clauses that will cause the insurance company to delay payment of cash for up to six months. Because emergencies can happen at any time, an individual may be inconvenienced if forced to wait for payment from an insurance policy. We generally do not recommended that life insurance cash values be used for an emergency fund. Likewise, credit cards should not be used for funding emergencies. Credit cards will only increase debt, making financial problems worse.
How much is too much?
An appropriate amount to save is three to six months worth of living expenses. The most conservative approach is to maintain liquidity to cover six months of fixed and variable expenses, however, some situations may warrant more or less. The amount of liquidity an individual keeps on hand in an emergency fund will likely depend on the individual’s comfort level and/or situation. It is important to recognize that, once money is withdrawn from the emergency fund, it should be replaced as soon as possible for future emergencies.
For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].