Posts Tagged ‘Financial Plan’

The Emergency Fund: Your Financial Red Cross

What do you do when:

  • your source of income suddenly stops?
  • you’re suddenly ill and insurance can’t cover all the costs?
  • you have to travel immediately due to a close relative’s passing away?
  • your car breaks down and you realize you have to spend $700 or more on repairs?

Sure you can use credit cards to cover some of these expenses, but how long can you do that for especially if the first situation is also true. This is when the Emergency Reserve comes into play. It sounds basic and like common sense, but this is the most important account for any independent person (and often the most overlooked). In discussing this, we can focus on the What, Why, Who, Where, When and How?

Emerg_Fig1

What: What is an Emergency Reserve?

According to the Merriam-Webster Dictionary Online, an emergency is

An unforeseen combination of circumstances or the resulting state that calls for immediate action

Two words stick out clearly here: unforeseen and immediate. Consequently,

An emergency reserve is money kept aside for unforeseen situations that call for immediate attention and action

This means that this money should only be used for things that are unplanned. Consequently, emergency reserve should be separate from your savings. Usually when we save, we are saving for a goal e.g. a vacation, new gadget, textbooks, accessories etc. As such, while savings is usually money for planned activities, an emergency reserve is money for unplanned activities. In a way, you can call your Emergency Reserve your financial Red Cross because it arrives on the scene when emergency rears its head.

Why: Why should I care about an Emergency Reserve?

As mentioned above, this money is for unforeseen circumstances which can (and does) happen to anyone. Thus the prime reason for having this reserve is simply: peace of mind. Rather than worry about money in a time of crisis, you know there is money somewhere and that helps to focus on the crisis itself. Besides, if you already insure your car and health, shouldn’t you also be insuring your finances as most emergencies hit the pockets first?

Who: Who should have an Emergency Reserve?

An emergency reserve is necessary for anyone who is (or wants to be) dependent on themselves for financial resources. Therefore, this person has some sort of regular income which pays their bills and they are not necessarily dependent on their parents or family members. This reserve is also important for those who have dependents.

When: When should I start an Emergency Reserve?

As soon as possible! Right after reading this article!! I’m kidding. Well kinda. In all seriousness, you never know when you will need this, so it’s best to start as soon as you can.

Where: Where should I keep my Emergency Reserve?

Since this money is required for immediate action, it should be kept in a savings account that is linked to a checking account. This way, the money can be easily transferred when it is needed. I would stress here that it shouldn’t be in a checking account simply because just as much as this money should be accessible, it should also be untouched. With an emergency fund tied into a checking account this is very prone to happen.  In addition, the advantage is that it generates interest while sitting in the savings account when untouched.

How: How much should an emergency fund have?

For this question there isn’t always a straightforward answer. I have heard of 1 month, 3 months or even 6 months worth of expenses saved. I have also heard of using figures like $1,000 – $5,000. I personally keep set my goal at $1,000 just because it’s a nice round figure and also because it covers a month worth of expenses at the moment. When I leave graduate school and start a family, I am sure that number will go up. The most important factor here is that you set a minimum that will give you peace of mind.

I’m hoping that I have somehow convinced you about the relevance of this very important financial tool or at least initiated some thoughts into starting your own emergency reserve. When crisis happens, you will have your own Red Cross to lean on.

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The Spending Pyramid: Personal Values and Financial Planning (Part I)

Do you ever find yourself wondering where the time has gone at the end of the day? It starts out bright and you perform the required tasks for the day, but the rest of the time has flown by before you realize it? This is often also the case with money.

In his book The Six-Day Financial Makeover, Robert Pagliarini warns that when spending isn’t planned, it often follows this pyramid with money flowing from the top to bottom and reducing in quantity as it trickles down.

Pyramid_Fig1

Like required tasks of the day, Basic Living Expenses are the first things that normally come out of a paycheck. You pay rent, water and electricity bills, insurance, buy groceries etc. However, if there is no plan in place for the rest of the money, whatever is left over often gets spent on Miscellaneous Expenses such as shopping, entertainment and the occasional dining out. Before you know it, there’s very little left over and this little is stretched into the remaining part of the pyramid. This is the kind of lifestyle that tends to lead to living paycheck to paycheck and a continuous cycling of debt.

Robert then suggested a different sort of pyramid which he termed the “Optimized Spending Pyramid”

Pyramid_Fig2

The top part of the pyramid is still Basic Living Expenses while the Miscellaneous Expenses lie at the bottom. Everyone in the finance field will agree that this should always be the case i.e. Pay bills first and then spend chump change on wants. The disagreements arise in the middle portion of the pyramid and the order in which those items should occur. Should Debt be paid off first before establishing Emergency Reserve? Should I give to Charity or the Church when I have debt piling up? Should I be saving for Retirement when I don’t have an Emergency Fund established? And so on and so forth.

The fact is there is not one correct answer. Even when there is an answer that makes sense mathematically, it can be hard to tailor emotions to the arithmetic. This is where personal values come into play. A bible verse says

“Where your treasure is, there your heart will be also.” (Luke 12:34)

The order of priority simply depends on how much value you place on each area of the pyramid. If it’s more important to you not to owe anyone anything, you will find yourself focused on Debt Reduction. If you care a lot more about things going on with the less-privileged in your community, Charity will rank higher in that pyramid. If you care a lot more about developing your skills e.g. learning new software for your job or improving your reading skills, Personal Improvement will rank higher on the list. Whatever the case may be, this portion of the pyramid will be ordered entirely on the things you value most.

Money, like time, if not planned wisely often trickles into the areas of life which don’t rank high on the priority list. Therefore establishing a plan is important, but more important is that it should be your own plan. When the created plan is yours and based on your values, you’re more prone or at least have a stronger desire to follow it.

As a follow-up to this article, tomorrow I will connect Dan Pink’s talk about the three aspects of motivation and relate it to how you can begin to arrange the middle portion of this pyramid to fit you.

Note: I found out this morning through Get Rich Slowly that Robert Pagliarini is offering his E-Book Plan Z: How to Survive the Financial Crisis as a free download. I haven’t checked it out but his Six-Day Financial Makeover was easy to read and comprehend and I expect this book to be the same.