Expect the unexpected
Preparing for financial emergencies may require you to change the way you think about money. It also may help you handle those emergencies when they occur. Preparation generally involves maintaining a comfortable level of financial resources, which can include savings accounts, retirement accounts and the equity in your home. Insurance also can provide you with the means to handle an unexpected financial need.
Preparing for every possible emergency is not practical, but a contingency plan generally can cover financial emergencies without accounting for a specific event. Remember, though, that your contingency plan may need to be reassessed and fine-tuned after an unexpected event. What follows are five of the most important ways to prepare for a financial emergency.
1. Maintain an emergency fund
The primary purpose of an emergency fund is to cover the sudden loss of income that typically results from unemployment or a health problem that prevents you from working. Financial planners also recommend creating a secondary fund, also known as a rainy day fund, to cover urgent needs that aren’t catastrophic. These include such expenses as medical bills, home repairs, and car repairs.An emergency fund should be able to cover three to six months of living expenses. You may be safe on the low end of this range if you have a stable job, no significant health issues, and no dependents, especially if your spouse is also securely employed. On the other hand, you may need more than six months of living expenses if you’re self-employed, work irregular hours and have dependents or a chronic health condition. The recommended range for your rainy day fund is $1,500-$5,000, depending on your age and marital and homeownership status. Young, single renters may be safe on the low end of this range, while older, married homeowners should stay at the upper end.
2. Develop a budget
Many household budgets can follow the traditional 50-20-30 rule by which essential living expenses do not exceed 50% of take-home pay. In this budgeting model, at least 20% of your take-home pay should go toward savings, while non-essential spending should be limited to 30%. Essential living expenses include rent or mortgage payments, groceries, utility bills, and insurance premiums. Savings include contributions to retirement funds, emergency funds, and debt reduction. Non-essential expenses include restaurant bills, travel, and entertainment expenses.
Developing a budget can identify areas where your expenses can be trimmed, even if that isn’t necessary yet. Non-essential expenses should receive the greatest scrutiny during this process, especially regular monthly fees for products and services that you are under-utilizing. For example, a membership fee for a gym that you rarely use is a prime candidate for removal from your budget, as is a cable package if you watch only a few of its channels. Wireless service may be an essential expense, but you can often find a better deal if you’ve had the same service for a while.
3. Reduce your consumer debt
Once you’ve topped off your emergency funds and retirement accounts, you are ready to begin paying down debt. You’ll save the most money by starting with the credit card that has the highest interest rate, but it’s often easier to generate momentum by paying off the card with the lowest balance first.
4. Optimize your debt
You may also be able to consolidate your debts into a single loan with a lower interest rate than your current card. Look for a card that doesn’t charge transfer fees or interest for an initial period, and ensure that you can pay off your balance within that window to make the transfer worthwhile.One way to optimize your debt could be with a HELOC. Using a HELOC, you can tap into your home’s equity to pay down the rest of your debt, and only have the HELOC payment to make. HELOC interest rates can be lower than many of the interest rates you’d pay on your other debt, so this could be a great option. There are many pros and cons to consolidating your debt with a HELOC, so make sure you know them before you make this decision.
5. Acquire credit
Acquiring credit may appear to conflict with the aim of reducing debt, but they’re actually different goals. During a financial emergency, you may need temporarily to rely on credit. That will require a good credit rating. The best ways to maintain a high rating are to pay your bills on time and to keep your credit balances low to ensure that your ratio of credit used to available credit remains low.
A home equity line of credit (HELOC) is a good way to obtain credit if you have equity in your home. This option allows you to borrow up to a maximum amount specified by the lender and based largely on your home equity. Because this type of loan is secured by the equity in your home, the risk of default for nonpayment dictates that you use it only for essential major expenses like paying off higher-interest debt, home repairs, medical bills, and education.
Figure’s HELOC is slightly different than traditional HELOCs. With a Figure HELOC, you are paid the full amount up front and then you can make additional draws on your home equity, as long as you’ve paid off some of your borrowed amount.
6. Obtain adequate insurance
Insurance should be a vital part of your plan for dealing with potential financial disasters. Life insurance is particularly important if you have a family since your family members will need money to live on if you die before retirement. The life insurance policy should also cover your children’s education in the event that you die before they graduate.
Health insurance is also a necessity for dealing with financial emergencies. The insurance premiums will increase your monthly expenses during your earnings years when you’re healthy, but when your health does begin to fail, you’ll be glad you have insurance. One serious accident or illness is all it takes to jeopardize your financial security.