Whether you call it a rainy-day fund, an emergency fund or a cash cushion, making plans to have significant cash available when bad things happen is fundamental to financial planning.
But what exactly constitutes an emergency fund? The most conservative definition — and most repeated advice — is cash equal to three to six months of living expenses sitting in a safe account earning minuscule interest.
Today, fewer than four in 10 Americans have an emergency savings account of at least three months of living expenses, according to a June survey by Bankrate.com. But those who have a cushion account take it seriously. They keep an average of $21,938 socked away.
So while it's true that cash is king for the safest emergency fund, some unconventional alternatives are available to the huge stash of cash. You'll have to decide what's right for you:
- Save for bare-bones expenses. During a crisis, such as a job loss, spending should drop dramatically. The focus should be on such expenses as food, mortgage or rent payments, car payment and utilities. So using the rule of thumb, you actually need access to three to six months of spending on necessities, which is likely to be far less than monthly spending during flush times.
- Start small. If you have high-interest debt, especially credit card debt, building a huge cash emergency fund is not a good idea. Paying off that debt is a higher priority. But it might be helpful to have a minireserve of cash to avoid adding more charges to the credit card. One idea is to save $1,000, or one month's worth of necessary living expenses, whichever is larger. Then attack and eliminate the high-interest debt before beefing up a cash emergency fund.
- Consider the two-income safety net. Two-income families have less of a need for a large emergency fund, especially if both earners make about the same amount of money. That's because a job loss, among the most serious of emergencies, doesn't wipe out the entire household income. A one-income family needs a larger contingency fund.
- Raise your credit card limits. Using high-interest credit cards is a very common but lousy way to address a financial emergency. If you're responsible with credit cards and rarely carry a balance, however, it couldn't hurt to ask your card company to raise your limits if you do it right. You must ask them to raise your maximum charge limit ''without pulling my credit report.'' That way, the request will not damage your credit rating. In fact, it could help if you're successful, because part of the credit score is based on the amount of used credit compared with the amount of available credit. A second advantage is the higher limit gives you a source of cash during a temporary cash-flow jam.