This article is an excerpt from Amortize Debt into Prosperity. This article was written by Marc Griffin and edited by Bart Griffin.
What is an Emergency Fund?
An emergency fund is a significant amount of money set aside in a special account in case of an emergency. Before we get in to why it’s important to have an emergency fund, lets look at a few key principles.
Never use your emergency fund unless it’s really an emergency.
Many people do the work to save up an emergency fund, but then justify tapping into those resources by calling everything an emergency. If your roof needs to be replaced, or your car needs new tires, those are not emergencies. Those things should be saved for in a budget, not an emergency fund. When you buy a house, you know at some point the roof will need to be replaced. Instead of just hoping it wont and then cleaning our your emergency fund when it does; estimate how long you have until it needs to be replaced and divide that by the total estimated cost to replace it to figure out how much you need to be budgeting for each month.
Pay off all consumer debt before starting your emergency fund.
It makes no sense to save money for an emergency at the same time you’re paying interest on debt. Interest you pay on consumer debt is much higher than what you can earn on savings, so you would be going backwards.
Emergency funds should be a minimum of 3 months expenses, but preferably 12 months or more.
What good is an emergency fund if it’s not enough to cover an emergency? You can’t predict what misfortune will happen, and misfortune finds everyone at some point. Make sure you have enough to cover yourself in the worst of circumstances. Let’s say you’ve saved 3 months worth of expenses, and then you get injured at work. Your emergency fund might be enough to make up for your lost income, but it won’t be enough to cover your medical expenses too.
5 Reasons to Have an Emergency Fund
You might find yourself asking “if needing new tires or a new roof aren’t considered good reasons to tap into an emergency fund, then what are some scenarios where I would use my emergency fund?”. Great question. The answer to that is when you encounter unexpected and unpredictable situations that will hopefully never strike but often times do. For example, you would never have a category in your budget for natural disasters or layoffs. It doesn’t make a ton of sense to save for those things individually, but still, what if either of those things happen? That’s why you have a multi-purpose emergency fund for situations like these:
Reason 1: Layoffs
I know first-hand what it’s like to lose a job because of circumstances beyond our control.
I worked for a $100 million manufacturer of avionics and aerospace products for 15 years before the Iron Curtain came down in Eastern Europe and brought the Cold War to an end in 1989. I lost my job two and a half years later as a result. Later, I lost another job when I worked for a commercial airplane manufacturer and the events of 9/11 ultimately affected the airline industry. It took each company years to recover from those events.
My first major job lay-off: In 1991, my wife and I took a chance and refinanced our home so we could add an addition onto our house. We took out a new 30-year fixed mortgage loan. As luck would have it, I was laid off in mid-1992 with four kids to feed and care for, three of which were six years old and younger.
I struggled with unemployment and temporary work for four years, while telling myself I would never let this happen to me again.
I vowed that if I ever returned to steady employment again, I would pay off my house as fast as I possibly could. We had an emergency fund and no consumer debt at the time, and we were able to pull through a very difficult period.
In 1996 I landed a steady, well-paying job, with Boeing. By the end of that same year I had the chance to pay off our house, and I did—in full, and oh what a great feeling of relief that was! By the time the events of September 11th, 2001 played out, we were better prepared for my next lay-off in December of that same year. Again, we had an emergency fund and no consumer debt, and better yet, no mortgage payments.
There is never a good time to get laid-off from work.
Especially when you’re in debt and have bills to pay, but it happens to just about everyone at some point in their life. The trick, when it happens to you, is to be financially ready at all times for that event. Have an emergency fund that can last at least 3, but preferably 12 months without relying on any other money source coming in.
Reason 2: Labor Strikes
Do you belong to a labor union? In all my years in manufacturing, I had only been a union member once for a relatively short period of time. Never have I personally gone out on, nor had the opportunity to go out on strike, but I have witnessed the results of the poor personal financial choices many union members made while on strike, and it goes something like this:
- They tend to have high consumer debt.
- They don’t have an emergency fund.
- They have little or no money saved to outlast the strike.
- They tend to pay their bills with credit cards.
- They live on and meet all of their future needs with credit cards.
- They expect a large signing bonus, and then its immediate distribution.
- They don’t seek or obtain temporary employment.
- They simply aren’t prepared financially.
The bottom line, if you belong to a union, you should know its history with the company you work for. Have an emergency fund saved up and never use a credit card while out on strike.
Reason 3: Medical Emergencies
Don’t be caught off guard! Accidents and disease can happen at any time, job or no job, health insurance or no health insurance. Even if you have a good job you could be the victim of an unexpected medical crisis, or an accident, and you could lose your job as a result.
A major medical event could occur to you or some member of your family while you’re unemployed. Medical crisis possibilities are endless. For example, there are more than:
- 36,000 deaths each year just from any run-of-the-mill influenza, and now we have the H1N1 flu, Bird flu and SARS to contend with that nations around the world are trying to keep at bay.
- 40,000 fatalities each year in automobile accidents.
- 200,000 deaths from medical accidents and mistakes in hospitals each year.
- 700,000 bankruptcies filed each year and most are due to health care issues.
These things can be financially devastating, even with a job and an emergency fund.
Reason 4: Natural Disasters
Flood, hurricane, tornado, earthquake, drought, land-slide, wild-fire, volcanic eruption or rising sea level are unpredictable. None of us know when or where they will happen, and we can only hope that none of those events will happen to us. But, they do happen to thousands of people every year, and unfortunately most people prone to these events are not covered by insurance. However, if you are covered, even insurance comes up short in many cases.
While insurance companies promise to make you whole again after a covered event occurs, those same insurance companies may fight you at every turn on technicalities.
Take for example Hurricane Katrina. Many big named insurance companies insured homeowners in that storm ravaged area, but refused to pay for all or part of the damages homeowners thought they were insured for. As a result, many people were wiped out financially because the lawyers for the insurance companies got them out of paying homeowners for damages on technicalities rather than doing what was right. Those poor people were neither in good hands, nor was anyone there for them, like a good neighbor.
Having an emergency fund would allow you to obtain temporary shelter and hang on to your job in a natural disaster, and, if necessary, allow you the financial means for a court battle with the insurance company should you file a law suit against them for denying your claim.
The following events may not be covered by standard homeowner’s insurance:
- There are tens of thousands of people in America who live 80 miles or less from an active volcano. Many of their homes are on a mud flow plain and in danger of being destroyed should a major eruption occur. Is there even an insurance policy available for such an event?
- Global warming may increase the likelihood of wild-fires occurring in areas of the country that have not experienced them before.
- The western half of our country is known for earthquakes, but did you know the eastern half of our country is overdue for a major earthquake? Eastern quakes have the potential for greater devastation over a larger area than in the western half of the country.
- And, how close to sea level do you live, including in-land? The world’s oceans are rising and your home may be vulnerable to floods, tidal waves, tsunamis, high tides, and/or damaging over-flow or spray from any of these conditions in the near future.
If you operate without a budget, have consumer debt, have no emergency fund and any of these conditions arise, you may lose everything.
Reason 5: Opportunity
Having an emergency fund can create opportunity in an otherwise bad situation. Sometimes unfortunate circumstances can turn out well.
For example: Sharon and Greg have been married for 10 years and are going to file for divorce. Fortunately, they have no kids and share very little material wealth. However, they did purchase a house together 7 years ago for $100,000 and now appraises for $153,870.00. They still owe a $92,242.15 balance on the mortgage loan. That’s a $61,627.85 net gain over the 7-year period. Sharon and Greg live in a community property state which means they must split all property accumulated through joint effort evenly upon the dissolution of their marriage. Sharon wants to keep the house after the divorce but doesn’t have $30,813.93 to pay Greg for his half of the net gain on the house. However, they will split all their personal property (i.e., two relatively new cars and a small amount of furniture and other household goods). They also have an emergency fund joint savings account in the bank totaling $20,000. But the account only earns 1.37 percent interest annually.
Sharon and Greg still share a very good relationship in spite of the pending divorce. So Greg would like to help Sharon keep the house. But she must pay him his share of the appreciated value somehow. His solution, if Sharon and all of the third parties agree, is to sell her his half of the house. The following is Greg’s offer, listed in the property settlement agreement portion of their divorce papers. Greg will keep Sharon’s half of the joint emergency fund savings account, which for him totals $10,000. Greg will also have Sharon sign a unilateral contract obligating her to pay him $20,813.93 at 1.37 percent interest over a 5-year.period, which is equal to the interest he would have otherwise earned at his bank. This contract would settle completely his financial interest in the house. If all parties agree to the settlement, Greg will generate an Amortization Schedule reflecting the settlement values of the loan contract. This will allow Sharon to retain possession of the house without refinancing it, which in turn would have entailed closing costs and acquiring a new 30-year loan all over again.
In the event Sharon sells the house, within the contracted 5-year period with Greg, she will pay him, in full, only the remaining balance due on the Amortization Schedule. This means all additional increases, or loses, in the home’s value since the contract was in force would belong to Sharon. Greg will retain Joint Tenancy in the house with rights of survivorship until Sharon satisfies the contract agreement.
This would have been a missed opportunity for Sharon and Greg had an emergency fund not been established early in their marriage.
The waste of money cures itself, for soon there is no more to waste.
– M.W. HarrisonThis article is an excerpt from Amortize Debt into Prosperity. This article was written by Marc Griffin and edited by Bart Griffin.