A common and significant misstep in the financial planning process is failing to plan for the worst case scenario.. especially for those early in their planning years. We all suffer, at one time or another, from the “it won’t happen to me” mindset. Many have yet to experience hard times and assume that will continue. Hopefully that will turn out to be true, but wouldn’t you like to be prepared just in case it’s not?
They say the wise hope for the best but plan for the worst. They accept that anything can happen and that sometimes things are just out of your control. Your actions are the one factor that you CAN control.
The first and most important reason you should hold cash is for the unexpected and worst case scenario. Some call this an emergency fund. Your emergency cash is your easiest insurance.
On top of your emergency fund, additional cash should be set aside for any expected short-term expenses or opportunities you know or expect are coming in the next 3 years.
So what qualifies as an unexpected emergency? When do you tap into your emergency savings account? Obviously job loss, lawsuits, and accidents. But what if your 20 year old AC unit blows up? No, this does not qualify. AC units have a 15 year lifespan and at this point it can happen any day – that should be an expected expense and planned for ahead of time. Save your emergency cash for actual emergencies.
How do you determine how much you should have in your emergency account? Well, there’s not just one answer. While everybody should hold some multiple of their monthly expenses in cash, this number will differ for everyone depending on their circumstances. And keep in mind we’re talking about expenses – not income. Here are a few scenarios to help get you started:
Let’s say you’re single – you rent your apartment, you ride your bike to work, you do not have any kids, and you have a very secure job. Because your liabilities and financial responsibilities are limited – you would likely need less in your emergency savings account than your Average Joe. Having about 2 months of expenses saved up for emergencies should put you in a good position.
Now let’s look at your more typical Joe – you’re married with two children, working on paying off that mortgage, you have two cars, and you both have steady jobs. If Joe comes into a time of financial hardship, he has a lot more financial responsibility on his plate than the single biker. If Joe unexpectedly loses his job, or falls ill, or has an accident, that mortgage still needs to be paid. The kids still need to be taken care of. Because of the increased financial responsibility, we would suggest closer to 6 months in this case.
On the other end of the spectrum, let’s say you’re retired and living off of your investments. Because you don’t have a guaranteed, steady income, you’re at a much higher risk than single-biker and Average Joe above. Your entire lifestyle depends on those investments. It would likely be wise for you to have closer to 24 months (2 years) worth of expenses in your emergency reserves.
Cash for the Expected
In addition to the unexpected, you’ll also have more predictable expenses that you should be saving for. These are expenses or spending above normal monthly values – they are not regular, but are relatively foreseeable. You should hold cash above and beyond the emergency fund level for these types of expenses coming in the next 3 years.
Examples of this include vacations, annual insurance payments, down payments, moving expenses, or taxes.
Don’t forget about the longer term expenses you’ll most likely have related to home and auto maintenance. Look at all of your owned assets and try to anticipate what’s likely to need replacing or serious repair in the next few years. For instance, if your roof is 10 years old and has a 15 year life expectancy, you should have 5 years to build up the necessary replacement costs. Take a few minutes to write down all of these predictable but longer-term expenses and use it to establish your target.
When determining your cash needs, start with your emergency savings and work to determine your multiple. If that number turns out to be 3 times your monthly expenses and you spend $5,000/mo, make sure you have $15,000 in cash. If you’re not there yet, be sure to make it your top priority.
Next, look at all of your larger expected expenses coming up in the next 3 years and total those up. This should be your major purchase savings target.
The best place to hold this cash is your savings account. We suggest keeping at minimum two separate savings accounts – one for emergencies and another for the expected “major purchases”. Establish your “rules” for each account on the front end. This emergency savings account must be off limits unless it’s an emergency. The major purchase savings should be only spent for those planned for expected major purchases.
We understand the interest rate is next to nothing on savings accounts, however, it is your best option for this purpose. This cash must be very accessible and not subject to any downside risk. If you look to increase your expected return with alternative vehicles, you’re also increasing your risk. This defeats the purpose of your emergency fund if it loses 50% of it’s value in a recession.
Some will consider using a Home Equity loan for emergency savings, but this does not really work as expected. Once again, you must assume you’re facing the worst case scenario. Home equity lines are not guaranteed and can be taken away. What if the market crashes or the bank goes out of business? What if you lose your job and they revoke your access to the line of credit? These are all possible downsides that, too, defeat the purpose of your emergency fund.
Having an emergency fund is the first line of defense in your financial plan. It is not only critical to build this up for the safety of your financial future, but also for your own peace of mind.