Wednesday, March 12, 2008

Emergency Cash Fund

What is an emergency cash fund and what does it have to do with personal finance?

What if you lost your job tomorrow? What about if your car broke down - or your fridge or washing machine. Would you be able to cope with this unplanned expense without undue financial stress? Would you need to borrow money at some exorbitant interest rate to cover the cost until the next payday?

An emergency savings fund is a store of cash or cash buffer put away to cover life's emergencies. No matter how well we plan things, life will always throw unexpected situations at us. This is where the personal emergency fund money comes into play. By having this extra cash put aside, you will be able to meet these challenges without the stress of trying to come up with extra cash at short notice.

There are almost endless possibilities when it comes to unforeseen financial emergencies. Here are some you might like to consider:

  • Breakdown of an important household appliance like a refrigerator,
  • A medical emergency,
  • Loss of employment,
  • Car repairs,
  • House repairs.
Some of these situations may require you to come up with hundreds, if not thousands of dollars at short notice.

If you can't come up with these funds at short notice, what are your options? In the worst case scenario, you may have to borrow money from a short-term money lender (think cash advance, payday loan or something similar) at very high interest rates. If you have a credit card, you may be able to use that, but once again you may face a steep interest bill. If you're lucky, you may be able to borrow the money from friends and family. However, not everybody is this fortunate, and even those that do have this option may prefer not to go down this path. Borrowing money from friends or family can place undue stress on relationships.

So how do you get started with an emergency cash fund?

Hopefully, you're in a situation where you're able to save some money on a regular basis. If you currently aren't saving any money, I would suggest you review your personal financial situation. You may need to cut back on your spending - have a look at your expenses and think realistically about what you can do without. Start with your discretionary expenses.

Assuming you are putting aside a little money each week or month, this is the money you should be putting into your family emergency fund. Set yourself a target (say $1,000) and concentrate on putting this much aside over a number of months. This should be your top priority and all of your saving efforts should go towards this goal until you feel you have enough put away.

It's important for this money to kept separate from the rest of your finances. You will need to resist the temptation to dip into it for special purchases - that new large screen TV or the holiday. Even worse, you don't want it to be frittered away on everyday living expenses. You need to make sure that the funds will be available should the need arise. Remember, it's for emergencies only.

How Much Is Enough?

I mentioned a figure of $1,000 earlier. This figure is somewhat arbitrary. I think it's a good starting point and is far better than not having an emergency fund at all. But I would suggest that most people would need more than that.

How much more? Well the consensus seems to be about 2 - 3 months pay (or even more). It will depend very much on your personal circumstances though. Factors to consider include the following:
  • How many dependents do you have?
  • How much if any health or medical insurance do you have?
  • How secure is your job?
  • What are your monthly expenses?
A young single person with no dependents could obviously get by with a much smaller emergency fund than a married couple with 3 dependent children and a mortgage. Consider each of the likely scenarios and work out how much you would need to meet the unexpected costs.

For example, you may allow $1,000 for a replacement refrigerator. You may also consider $2,500 to be enough to cover any major car repairs. And you may think that 2 months would be long enough to seek alternative employment, and if your living expenses are $2,000 per month then you would need to put aside $4,000 to cover this eventuality.

In the above example, you might like to set the amount for you emergency fund at $4,000 as this is the greatest figure out of the scenarios you have considered. It's unlikely (but not impossible) you would encounter all of the above situations at once, so I would just make sure I have the most expensive one covered.

Where Should You Keep Your Emergency Cash Fund?

Because in the event where you need to make use of your emergency fund you will need access to the money at short notice, I would suggest you keep it in cash or a cash equivalent. This means an at call savings account (maybe on online savings account to maximize the interest you can earn). Or you may want to consider a short dated term deposit or CD (certificate of deposit). The main thing to remember is that should you need to call on your emergency fund, you will most likely need the cash in a matter of days.

Many personal finance experts may consider an emergency fund to be an inefficient use of your resources. In some cases this can be true, but it will depend on your personal circumstances. In my next post, I will discuss more advanced concepts in managing your emergency cash fund.


Thursday, March 6, 2008

Personal Finance Basics - Where To Start

Are you trying to get your personal finances organized? This article will help get you started.

Lots of people have good intentions when it comes to personal finance - they just don't know where to start. And it's not always easy. Everyone's situation is different - there's no one-size-fits-all solution. You may be in a situation where you have trouble making ends meet from week to week. Or you may have a decent income coming in each week but never seem to have any money left at the end of the pay period. There are even those among us who have managed to save a little money but are not sure what to do next.

Take Stock Of Your Personal Finances Now!

The first step you need to take is to work out where you are now. This is essentially establishing what you financial position is now. What are your assets and liabilities? How much income do you have each month? How much do you spend?

What Are Your Assets?

This can be a tricky question. How do you work out what an asset is? The simplest asset to identify is cash in the bank. Next will be any investments you have - stock market, real estate, retirement fund and so on. Then, if you own (or have a mortgage over) your own house you might like to include this next.

Now comes the gray area. Some personal finance books will tell you that lifestyle purchases like cars, boats, televisions and stereos are not assets. They argue that these "assets" wont appreciate in value and in many cases will have very little resale value. And in the worst case scenario, they may have high maintenance costs associated with them. I'm not going to say whether or not you should include these things in your list. I tend not to include them, but it's up to you. You should be going though this exercise (establishing your financial position) on a regular basis and the most important thing is to be consistent over time in what you record.

For each of the assets you've listed, assign a dollar value. For financial asset (like cash, mutual funds and stock market investments for example) this will be easy. For other things you may like to record the purchase price. In cases where the monetary value of the asset diminishes quickly over time, you might like to allocate a value based on how long you've had it and how long you think it will last. Better (and easier) still, just don't include it as an asset. Consider it as an expense - like a night out or a weekend away.

What Are Your Debts?

This should be a little easier than the assets - as most lenders will remind you frequently of how much money you owe them. Write them all down. Include any money owing on your mortgage, personal loans, car loans, credit card debt, student debt, store cards and so on. Now write the amounts next to them.

Do You Owe More Than You Own?

The next step is to add up all the values you allocated to all of your assets and write down the total. Now add up all of your debts and write down the total. Now the moment of truth - subtract your total debt figure from your total assets figure. What do you get? Is it a positive number or a negative number.

If you got a negative number, don't panic. At least we know where we stand. You should be happy that you now have a basic idea of your personal finances and how they stack up. Knowing how much net debt you have will give you something to focus on. Each month, you will want to try to reduce the deficit of assets to debt. You may not improve every single month, but overall you want to see a steady improvement over time.

If you subtracted your debt from you assets and got a positive number, well done. Don't become complacent, but you must be doing at least something right to be in that position. Either though hard work or maybe just good fortune you are ahead of the game - but by how much? Or maybe a better measure would be to look at the total interest you are paying on any debts you may have, then compare this to your income. You may have more assets than liabilities, but are you moving in the right direction?

In my next article I will be looking at what our next step should be. How does our income stack up against our expenditure? Please come back tomorrow to read the next article in the series on personal finance basics.


Tuesday, March 4, 2008

What Is A Personal Finance Budget?

How does budgeting apply to personal finance?

Budgeting is one of the most basic personal finance tasks you can undertake. A surprising number of people have never even given this subject any thought and fewer still have even attempted to prepare one. So I have deciding to write a series of posts on personal finance budgets - what are they, why do you need one and how do you create one?

Today I will answer the questions - what is a budget and how does it apply to your personal finances?

So What Is A Budget?

A budget is generally a plan which is financial in nature and which maps out expected income and expenditure. Governments have budgets as do corporations. Governments need to understand how much expenditure is planned in what area and when the expenditure is due to occur. This then allows the government to plan what income is needed to cover these expenses. They then have the choice of adjusting taxation policies and debt levels in and effort to match expenditure against cash flows. In a similar way, corporations of all sizes will undergo similar activities to ensure continuing operations and profitability.

A personal or household budget is essentially to same as a government or corporate budget except that it is done on a smaller scale and at a micro level. Granted, an individual wont have the same financial resources as a government does, but the principle is the same.

So a budget is all about understanding what your expected income is over a given period and what your planned expenditure is.

Income could be salary or wages from paid employment. It could be interest on a bank deposit, dividends from stock market holdings or some other form of investment income. Income could equally be a government benefit, pension or other allowance. If you are helping your children set up a simple budget, it could just be their pocket money. Income could even be your regular winnings from the blackjack table or at the racetrack (only joking - nobody wins on a regular basis playing blackjack or betting on the races do they?).

Expenditure is anything you spend money on. This will be things like food, fuel, utilities, clothing and medical expenses. It also includes things like credit card payments, mortgage repayments and other debt servicing costs.

The other items that will appear in the outgoing section of your budget will be things like savings and investments. By this I mean the money you want to put aside each month to contribute to savings and investment plans. It's important to include these items in your personal budget so that they are part of your plan. Planning to save money is the first step on the way to saving money.

How Has A Budget To Do With Personal Finance?

A budget is one of the fundamental building blocks of your personal finance plan. It helps you to understand where your money is coming from and where it is going. You will use it to determine how much excess cash flow you have available each month (or maybe even how much shortfall there is). You can then put the excess towards debt reduction strategies to help you get out of debt. Alternatively you can put the excess to work in the stock market, a mutual fund, a real estate investment or any other type investment that will help you to grow your wealth.

And if you budget has a shortfall, you'll be able to identify it then take steps to address it. Maybe that car loan is too expensive. Maybe you need to re-think your personal loan rates. or you may just be living beyond your means.

Your budget doesn't have to be complex - a pencil and paper will do. However I suspect that excel spreadsheet budget planning is probably the most common method. In an upcoming article I will describe the process of actually preparing a budget.

For now, start thinking about where your money comes from and where it's going. Then keep an eye out for my upcoming article on how to prepare a personal finance budget.