Personal Funds
Every independent individual needs to build and maintain two funds:
- Emergency Fund
- Safety-Cushion Fund
It's all about the risk
Every individual person faces multiple risks throughout his/her whole life. For example: risk of breaking leg or arm, loss of job, loss of health, car crash, fire, dismemberment, and death. The financial impact of such events may be devastating to that person and his/her family. That's what the insurance is for.
Imagine the worst case scenario: you crash your car into your house, you injure yourself and your family, your house burns down to the ground and the car is damaged beyond repair. You lose everything except your bank accounts.
Emergency Fund
Usually, in case of an unfortunate event like a car accident, an insured person has to cover at least some part of the costs. That's what the Emergency Fund is for.
You will need money for all that deductible part of every insurance you have. Add up all your deductibles, then add some extra margin (about 20-30%) and that's the amount you need for your Emergency Fund. Practically, most people need at least $5,000 of cash reserves put aside for emergency situations should they occur.
Safety-Cushion Fund
In that worst case scenario, you and your spouse won't be able to work until full recovery. That's what the Safety-Cushion Fund is for. You'll probably need at the very least a half of a year before you recover and find a new job. You'll need the amount of cash to cover your average living expenses during that time. More conservative assumption requires one year of average expenses. It may be wise to also add about 20-30% margin for some extra cushion. Practically, most people need at least $12,000.
Buying insurance tips:
- In general the insurance is there to cover the costs of the most catastrophic events only. For example, when buying a car insurance, choose the highest deductibles. This way for the same money you'll be able to afford more coverage. Think about it this way: the insurance company profits from insuring the catastropnic accidents, while you profit from insuring the low-cost accidents.
- If your employer offers any long-term disability plan, take it. The benefits of having it outweigh the costs.
- Most employers offer health and life insurance. Usually it's very cheap. Take it.
Building and managing the Funds
The Emergency Fund must be very liquid and easily accessible. You never know when you're going to use it. Keep it in a high-yield savings or money market account. Check BankRate.com for best yields.
Try not to mix the Emergency Fund with savings for other causes like: a new car, a downpayment for a house, or vacation. Open a separate savings or MMA account at a different bank for such savings and a separate for the Emergency Fund.
Depending on your saving rate, you'll be building your Emergency Fund for several months up to several years. You do the math.
The Safety-Cushion Fund doesn't have to be as liquid as the Emergency Fund. The best idea is to build a CD ladder. Mostly because CDs offer a bit higher yield. If you plan to build Safety-Cushion Fund that covers half-year of your average expenses, then build the Fund by buying one 6-month CD every month for 6 months in a row. After six months, the first CD matures. And from now on, one CD will be maturing every month. Usually, if you don't withdraw the money in about 7-day period after maturity date, the bank will renew your CD at a new rate for another 6 months.
In the real world building the Safety-Cushion takes some time. First, put the money you save in a high-yield savings account. Every several months when that amount grows above the level of the average monthly expenses and there's no CD maturing in this month, buy a new 6-month CD. Repeat until you have six of them. When it's complete, you may choose to increase your Safety-Cushion Fund up to one year by buying additional CDs and increasing CD term. Once you understand the concept, you'll know how to play with it.
A person saving 20% of his/her aftertax income will be building the 6-month Safety-Cushion Fund for 2 years. Takes time but it is worth the effort. The formula to calculate number of years necessary to build a Safety-Cushion Fund is: (expenses/savings)*(months/12). The more one saves, the faster he will build the Funds.
Currently, there is no better place to keep Safety-Cushion Fund than I-Bonds from TreasuryDirect.gov. But the minimum holding period is 1 year, so it is only for people who already built the Fund in amount of 1-year of average expenses.
When it's done
When you complete building Emergency Fund and Safety-Cushion Fund, it's time to start saving for a downpayment to buy a house or to start investing, or to start a business. Many experienced investors say: Invest only the money you can afford to lose. The money you can afford to lose are only the money which will have no impact on one's finances in the nearest future. This rule applies equally to investing in stocks and to investing in a private business.