Monday, March 16, 2009

How much emergency savings is enough?

Every Monday in this space we’ll take a question from a reader. Today, we’re talking about cash and how much you need. If you have a question, feel free to post in the comments section and we’ll answer it on a Monday.

Question: I’d like to save up money for an emergency, but I read different estimates of how much a person should have on hand. How much emergency savings should a family have? And where should that money be kept?

Answer from Dan Danford: Right now, cash is valuable because of principal protection, not because of earnings potential. Many savings, checking, or money market accounts pay less than one percent annually, so it's not a lucrative investment. Still, the notion of ready cash has value and every family should have some emergency reserve.

The amount differs by situation. A lot of advisors recommend six months of income, and that has merit for many folks. It's also a problem because some families simply can't accumulate that much in brief time. Dave Ramsey suggests that you start with a $1,000 emergency reserve and I like that idea because it's attainable. Once you reach $1,000, it's easier to keep adding until you have all you need.

Not every family needs six months, however. If your family has great credit and solid professional prospects (superb job skills or desirable expertise), short-term borrowing could ease any emergency situation. I'm not certain six months of cash earning one percent a year is the most productive use of resources. For these lucky folks, two months might be plenty adequate.

One of my most fervent beliefs as an advisor is that flexibility reigns king. In other words, the ability to adjust is one of life's critical financial needs. Cash - liquidity - creates that ability and has value for that reason, too. But liquidity doesn't necessarily mean bank accounts or money market funds. It can also mean other investments which might be liquidated on short notice, like mutual funds. Sometimes life changes very quickly and we need to respond quickly, too. Both challenges and opportunities happen fast and being able to put our hands on some quick cash might make a huge difference for the future. So, even among permanent investments, structuring them for easy access is important.

My Boy Scout advice is to be prepared. That may be money in the bank but it also may mean borrowing, or in some instances, tapping a longer-term portfolio. Live each day as if a lay-off is right around the corner and you'll be in great shape no matter what comes.

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