How to Set Up a Financial Safety Net
Financial difficulties like recessions, job layoffs or reduced salaries have a way of revealing how important it is to build a financial safety net.
Having funds available for emergencies helps weather the inevitable storms of life and can get you through some difficult circumstances without incurring credit card debt.
Here are some things to consider when establishing your emergency fund.
How much is enough?
Generally speaking, most financial advisors will recommend you have at least three to six months worth of expenses in a cash reserve.
Depending on your situation you may want more. For example, if you have a commission-only job and your income fluctuates or you have a seasonal job where your income is low for a few months out of the year it might be wise for you to establish a larger net.
How do I begin establishing a cash reserve?
If you find your reserves are a little anemic, consider these steps to start the process:
- Take inventory of your monthly expenses. Multiply this number by your desired reserve (i.e. 3 months, 6 months etc)
- Make a budget so you can begin to “trim the fat”. Cutting back on unnecessary expenses will free up extra cash that can be saved into your reserve.
- Get creative on making additional money. Sell your old “junk” on ebay, or have a garage sale. Use these proceeds to start building your emergency fund. My wife and I have made some extra money these last few years by selling our old cell phones, clothes and more on ebay.
- Save aggressively into a savings account. There are many great accounts out there. Bob at ChristianPF has a post on the 10 reasons why he loves ING. If you like using local banks, I suggest calling around to find out who is offering the highest interest. Otherwise if you are comfortable with online banking then check out bankrate.com. They allow you to search the highest yields at banks both locally and nationally.
- Don’t dip into your reserve unless absolutely necessary. One of the biggest mistakes people make in setting up cash reserves is a false sense of now “having money to spend”. Stay focused on the task at hand. After you’ve built up your cash reserve feel free to reward yourself. Just remember this money is for a safety net.
I built up my cash reserves – now what?
Once you’ve reached your goal for your cash reserve it’s time to get strategic about earning the most interest.
I usually recommend a Three Tier Cash Reserve System to help keep the funds liquid and yet earn a higher rate of return.
A three tier cash reserve basically utilizes a checking account, a money market and a short term CD Ladder.
Tier 1 consists of your checking account. It acts as your revolving door, meaning funds come in and go out on a regular basis.
Since most checking accounts pay nothing, you want to keep no more than one months worth of expenses here.
A money market fund is designed to provide a safe place to invest short term liquid assets. They typically generate a higher interest rate than a savings account.
If you are using a three month reserve you’ll want to keep about a months worth of expenses here and about two to three months worth if using a six month reserve.
A short term CD Ladder is essentially a 12-month CD bought each quarter or four total. Divide the remaining amount of your reserve by four and buy a 12-month CD. In three months do the same thing and so on.
If you fast forward one year from now, you will have a CD coming due every three months in case of a major emergency and need to access the funds.
Theses ladders can be structured in various ways. For example, you could buy a 3, 6, 9, & 12-month CD all at once if your bank offers those terms. You could also buy 12, 24, & 36-month CDs to ladder your funds. I am a big fan of the 12-month CDs for two reasons:
- They typically offer higher interest than the shorter term CDs
- You don’t have to lock up your money for a longer time period. Since this is a saftey net, you don’t want to be in a position where you are cashing out a longer-term CD early and incurring a penalty or forgoing interest.
Set Targets and Avoid Discouragment
Don’t be discouraged if you are not able to get your cash reserve set up like this yet. The key is to stay focused on saving your money so that you can get your emergency fund where it needs to be.
Set a target for yourself of when you’d like to achieve this goal and also set little goals along the way (i.e. saving your first $1,000, getting Tier 2 set up etc.).
Be sure to reward yourself along the way when your goals are met so that you can stay motivated and positive.
Saving for Emergencies or Paying Down Debt
Inevitably a question will come up from time to time about whether it is smarter to save into an emergency fund or pay down credit card debt?
I like Dave Ramsey’s “Baby Steps” idea when faced with a question like this. What he usually recommends is that you save $1,000 into an emergency fund first and then start paying down your debt.
You can worry about building up your Three-Tier Cash Reserve once you have your debt wiped out.
Resources To Help
- Bankrate.com – compare interest rates on savings, money markets and CDs from banks across the nation.
- Dave Ramsey’s Baby Steps