In another post, we talked about employer-provided disability insurance – and the shortcomings of it. One of the problems is the gap in coverage – which could leave an individual without income for more than three months!
Fortunately, a very simple solution exists: creating an emergency fund!
What is an emergency fund?
An emergency fund is a cash reserve to be used only in times of an emergency. A good use of an emergency fund is:
• to get you between the time short-term disability benefits end and long-term disability benefits begin
• to pay for unanticipated non-discretionary expenses
• such as a medical bill for an unexpected illness or injury
• an unexpected automobile repair
• an unexpected home repair
Your emergency fund shouldn’t be used for discretionary expenses – such as a vacation, or a new big screen television.
Why do I need an emergency fund?
An emergency fund is your financial defense against unforeseen consequences. By always having cash on hand, you’re less likely to find yourself in a tough financial situation: such as having to hit up family and/or friends or cash, or taking out a personal loan at extremely high interest rates.
An emergency fund is your financial defense against unforeseen consequences.
Having an emergency fund can also help you save on insurance expenses. With a sizable emergency fund, you can afford to self-insure. That means paying less money to the insurance company – and keeping more of your money for yourself. You can do this by raising your insurance deductibles – be it on your automobile, home, or even by opting for a high deductible health plan.
How much should I have in my emergency fund?
The Certified Financial Planner Board of Standards, a non-profit that aims to set standards in the profession of financial planning, likes the idea of having between three and six months of living expenses. That’s a broad recommendation that does not necessarily apply to employees of the Big Four. Given that employer-provided disability has a gap of more than three months, it makes sense for staffers of the Big Four to have enough have cash saved to cover this three+ month gap. Therefore, three months of living expenses alone won’t cut it. You’re going to need more.
Creating Your Emergency Fund
Your emergency fund should be in cash. Certificates of Deposit (CDs) are okay too. Your emergency fund should not be invested in stocks, or risky or long-term bonds. Remember, your emergency fund should be easy to access and not subject to decreases in value.
Your emergency fund should not be invested in stocks, or risky or long-term bonds.
Given the current low investment return available for cash, having up to six months of living expenses sitting in cash may be difficult to stomach. Unfortunately, you will just have to deal with it. You can consider the low current return a fair price for knowing that the money will be there when you need it.
If you’re up for doing a little bit of work, you’ll likely be able to find a better interest rate for your cash at an online institution (rather than what is available at your local brick and mortar bank or credit union). NerdWallet has a list of banks that offer the best interest rates for a savings account.