Prepare for a Rainy Day (Part 1)
One of the bedrock components of any financial plan is the Rainy Day (or Emergency) Fund. This is a certain amount of money most financial planners recommend their clients set aside for unforeseen events requiring cash outlays beyond our normal budget – “Known Unknowns” if you will.
While only given lip service by some, in my view, a properly-sized Rainy Day Fund enables practically all other parts of the financial plan, thus making it a vital part of everyone’s financial plan. Without an emergency cache of ready cash, all other parts of a viable financial plan are compromised. Let me say that again – ALL PARTS OF THE PLAN ARE COMPROMISED WITHOUT A RAINY DAY FUND.
That may sound alarmist – well, that’s intentional. While we can debate the amount, the need for an emergency fund is undeniable. Life happens – tires need replacing, air conditioning units break (almost always in August), relatives pass away unexpectedly, and sometimes even jobs are lost. The circumstances where we may need ready access to cash are too numerous to summarily discount.
If one chooses to forgo an emergency fund, barring the kindness of strangers, a sampling (I don’t claim this list is exhaustive) of other options where one could turn include the following:
Home Equity. Since the most significant percentage of wealth for most Americans is the equity in their primary residence, repeatedly accessing it stunts, perhaps permanently, home equity growth. Moreover, as we learned in 2008, home prices move up AND down, the latter of which can erode home equity. To be prepared for all scenarios, do not consider for immediate cash needs.
Long-Term Investments. Just the title is self-critiquing as to why this is a bad idea. Long-Term Investments frequently need relatively long periods to achieve the growth one seeks in this asset class. Markets ebb and flow, so if your cash need arrives when the market tides are out, you are “selling low”, which is exactly what an investor does not want to do during market downturns.
Retirement Assets. This is even less desirable than the choices above. Retirement Assets are just for that, retirement – not a new set of tires. Admittedly, there are programs in place to take loans from your retirement accounts and you are paying yourself interest. However, I would argue that one should use that mechanism as an absolute last resort as the caveats associated with such a financial decision can snowball (i.e. a relative passing soon followed by a lost job). This compounding effect can result in the innocent loan being characterized as a distribution and the associated tax consequences.
Credit Cards. This is a common comeback to the Rainy Day Fund argument and one with which I vehemently disagree. To me, credit cards serve two purposes:
(i) As a convenience for the protection they bring for your purchases (near 100% acceptance and warranties provided by the card provider); and
(ii) As a means to garner loyalty rewards (cash back or “points”).
Credit cards are not, I repeat not, an efficient financing mechanism. Prevailing credit card rates are simply too high...they always will be. And for those who think the teaser 0% APR rates are a retort to this statement – here is a secret: the credit card companies are offering those deals to benefit themselves, not you. Simply put, I’d rather earn 0.05% in a savings account than pay 10% APR when the inevitable happens. If you want to dismiss the inevitable, try and remember a calendar year where you didn’t have a single month where outflows (spending) exceeded inflows (income).
So, despite how unsexy the Rainy Day Fund is, clearly it warrants significant attention. In addition to giving you the confidence to handle whatever curveballs life throws at you, it will bolster the other, sexier parts of your financial plan that need to be left alone to grow uninterrupted over long stretches of time.
And if you still are not convinced, I refer you to Page 22 (and the facing page) of the 2010 Berkshire Hathaway Annual Report – I actually recommend you read all of them in their entirety with a highlighter in hand. There you will find a far more eloquent discussion about the importance of liquidity from a far wiser source than me.
The size of the Rainy Day Fund and some techniques for accumulating one are topics of succeeding articles.