NEW YORK (MainStreet)Stashing away a few bucks in case of an emergency seems like the sensible thing to do, especially if a curveball heads your way.
If you have a rainy day fund in place, you can tackle the problem easily and avoid jeopardizing your financial security or even credit score. Setting up an emergency cash fund gives you options to replace the broken radiator or take that unexpected trip back home.
Even if you can use your credit card, it's better to use your cash so you can avoid high interest rates or other fees. It's always good to have some cash handy that you can access quickly from your bank.
Starting your emergency fund can be as simple as stashing $50 a month into a savings account, said Nick Drew, a financial advisor for Liberty Partners Financial Services, LLC, based in The Woodlands, Tex.
He recommends that you open an account at another bank or credit union so that the money is "out of sight and out of mind." Automatic debits are one of the best methods, because the money is taken out of your paycheck each month, preventing you from spending it.
"Just start doing something and increase it every quarter," he said. "People are amazed how they can easily save $50 a month and increase it to $100 a month and wind up with thousands of dollars in savings in less than two years."
While most financial advisors have traditionally advised saving three to six months of your expenses, the downturn in the economy has made some people more cautious.
If you work in a field that experiences frequent turnover, you might consider saving 12 months of expenses, said Drew.
While savings and money market accounts are paying under 1% in interest at traditional banks and even credit unions, a better option is to invest your cash in CDs. Expect a greater yield with a longer maturity.
One option is to buy several CDs with various maturities or what is known as "laddering."
"CDs can be a safe way to diversify the underlying investments in an emergency savings account while generating a higher yield," said Eric Greschner, a financial planner at Regatta Research & Money Management, LLC, based in New Orleans.
"Make sure that the fund is liquid so you can tap into it if and when you need it," he said. "You never know what can happen in life. Those unknowns can be an illness, a car accident, job loss or a divorce. It is better to plan in advance for the unexpected."
CDs are sold with short-term maturities such as three or six months. At the end of the maturity, you should reinvest the principal in another six month or even 12 month CD.
If you need money for an emergency, then tapping into a CD is not an issue, because investors do not pay a penalty and lose only a small portion of the interest they have earned, said Drew.
Steer clear of buying stocks for your rainy day fund. While buying stocks may seem like an attractive option since the returns are extremely high compared to a money market account or CD, they can be volatile, said Greschner.
"Avoid stocks, particularly highly volatile ones, as they can often decline considerably during market sell-offs," he said. "If the emergency funds were unexpectedly needed at the same time a market sell-off was occurring, an investor could potentially be forced to sell at an inopportune time. Making sure the money is there when you need is the one is a top priority."
Investors should avoid the temptation to reduce the credit quality or extend maturities to increase the yield. Instead, they should favor highly liquid, higher quality investments with shorter maturities so the cash is safe and easily accessible, said Greschner.
Allocating more money into your rainy day fund can be achieved easily, said Drew. Avoid using money from a raise, bonus or tax return and instead stash that money into your emergency fund.
Once you have paid off a large purchase such as a car, you should invest the same amount into your emergency savings account, he said.
An emergency cash fund prevents you from borrowing money at unattractive rates or being forced to tap into a retirement account. Borrowing money from a retirement account should be avoided, because there is a 10% early withdrawal penalty and a tax liability.
Investors who are more aggressive or saving for longer time periods, like when looking to purchase a house, can invest their cash reserve in a mutual fund with tax exempt municipal bonds, said Drew.
"Investors will see better yields of 4.5% to 6% instead of money market rates of less than 1%," he said. "You are getting a real rate of return without increasing your tax burden."
Even if you have to withdraw cash for a crisis, a rainy day fund will prevent more stress and problems in the future. Replenishing the fund as soon as possible is key to maintaining your financial security.
"Procrastination is very prevalent," said Drew. "Once you start an emergency fund, you will have less of a tendency to use it. Your money will just build and build."