The world of money, markets and financial security can quickly become murky and ambiguous for many people. But the most basic characteristic of a financial plan is clear and simple. Before you think about how you’ll afford to retire, put children through college or understand how to invest wisely, the foundation of any plan should be to avoid hardship.
Unfortunately, a significant portion of your friends and neighbors may only be a medical bill or lost job away from a serious struggle to make ends meet.
The easiest way to get into financial trouble is to not have a cash cushion for emergencies. It’s a basic, even boring, step on the path toward financial security but it is the first step and it should never be skipped.
An emergency fund is often discussed in terms of what you should have set aside if you lose your job. The basic recommendation is to have three months of expenses saved up if you are a two-earner family or six months of expenses for a single-income family, particularly one with children.
Potential job loss may be the most obvious reason to build savings but hardship can be created in many other ways. At least with job loss, you may receive unemployment benefits. With other sudden needs, that’s not the case.
The leading cause of bankruptcy is unexpected medical bills. They add up fast even for relatively non-life-threatening issues. The annual out-of-pocket maximum under most health insurance plans exceeds what many people have set aside for emergencies.
Even without job loss and medical bills, there are other common occurrences that create hardship without an emergency fund. Costly vehicle repairs could arrive unexpectedly and add no value to your vehicle. They are purely a sunk cost.
And it doesn’t have to be high-cost one-time events that create hardship. Sometimes, it’s simply a growing cost of living. Children may become more active in sports, music, or other clubs. They need braces. Your rent may increase. Your commuting costs go up. Add them all together and savings can be eroded, especially since today’s interest rates on savings are way below the growing cost of living.
Traditional banks pay next to nothing on savings accounts. Don’t expect this to change anytime soon. The Federal Reserve’s Zero Interest Rate Policy has had payments on cash deposits stuck near 0 percent for four years now. As recently as 2007, the average $25,000 six-month CD generated $1,310 annual income. The same CD this year would pay about $97.50.
Online banks with high-yield savings accounts (i.e., Capital One, Ally) are the most attractive current option for cash since they pay higher interest rates. They are easy to link to your bank account and move money back and forth electronically. They generally do not have fees. Another cost-free option is U.S. savings bonds, particularly Series I inflation-adjusted bonds, that you can buy at TreasuryDirect.gov.
From a financial planner’s perspective, here are several other ideas to consider to avoid financial hardship.
• Take care of the things you can control because things you can’t control will happen and you need to be in position to respond. You can control your job preparedness and basic education. The more secure job you’re able to acquire the better you’ll be able to protect against the risk of hardship. Learning on the job and improving your skills to advance your pay may be the easiest way to grow beyond the vulnerability of short-term hardship.
• Live on less than you make and pay yourself first before your bills so that you can build a cash reserve. If it means you have to accept a standard of living less than you desire, you’ll have to get comfortable with that until your finances are more secure. This is preferred compared with other common choices that may increase financial troubles. Many people expect to fill up their credit card limit if unexpected costs arise. Or they count on taking a withdrawal or loan from their employer’s retirement plan. Some even consider home equity loans as their emergency fund. These options should be considered last resort.
• Keep in mind that many of the causes of hardship are rooted in being underinsured. In addition to health coverage, disability and life insurance are essential elements to protect against the risk of losing your ability to earn income. Again, these are benefits that a good job can assist with. But you may need to supplement employee benefits with personal insurance policies to be adequately covered.
Ideally, good savings habits and planning will not require your money to be used in a hardship case and when your emergency fund grows larger than is necessary, you can put some of it to work toward more enjoyable goals in your life.Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma.