Building an Emergency Fund
An emergency expense fund takes time to build. But you will be glad you have one when an emergency strikes and the bills start mounting.
They are guaranteed to happen at some point during your life. But there's absolutely no way to predict when they will transpire. However, they most likely will occur at the most inopportune time-like the week you get back from a luxurious vacation or right after purchasing a big-ticket item such as a 50-inch plasma TV.
What we are talking about here are emergency expenses. They arrive in the form of such things as a leaking roof, blown car transmission or a cracked sewer line in your front yard. Some are just minor inconveniences, costing a few hundred dollars to set right. Others are major headaches that can set you back thousands of dollars.
Here are five strategies to help ensure such emergencies don't turn into major financial disasters.
  1. Start an emergency fund. The last thing you want to do is tap into your monthly expense budget or retirement account to pay for an emergency expense. Although the latter may seem like an attractive option, it isn't, as it can adversely affect your retirement savings. A better option can be to create an emergency fund. A good rule of thumb for the size of the emergency fund is to have enough money in it to cover your expenses for at least three months, though ideally it should be large enough to keep you afloat for six months absent any other income.
  2. Replenish your emergency fund ASAP. Once you take money out of your emergency fund, you should replenish it as soon as possible. This may require a making some sacrifices, such as eating out a little less frequently or cutting back on those daily lattes.
  3. Apply for home equity line of credit. It's always a good idea to have a backup plan in case you don't have enough cash on hand to cover an emergency expense. One option is to apply for a home equity line of credit. Because home equity loans usually carry high interest rates, it is often best to exhaust other options first before using a line of credit. Additionally, you should pay back the loan as quickly as possible.
  4. Review your home and auto insurance policies. Every year you should review all your home and auto insurance policies. These help to ensure you have adequate coverage in case of a major catastrophe, such as a flood or fire.
  5. Pay off your debts. One of the easiest ways to cushion the blow of an emergency expense is to reduce your debts—especially credit card debt. It's much easier to build and replenish your emergency fund if you have a lighter debt load. This can give you much more flexibility to manage your cash flow in the way that best meets your needs.
Although it's tempting to use your emergency fund to pay for a non-essential expense like a vacation or new car-resist it. It can take a long time to build an emergency fund and you will be glad you have it when the bills start piling up in your mailbox. It also will help reduce the temptation to take a loan from your retirement account, which can severely impede your ability to achieve your retirement income goals.
If you find yourself in a financial pinch-bills to pay but no available cash to do so-it's worth taking a moment to assess your options. Some can be decidedly better than others. Click here to learn about the pros and cons of each option.
  1. Your own emergency fund
  2. Longer-term assets in taxable accounts
  3. Roth IRA
  4. 401(k) loan
  5. Home equity line of credit
  6. Traditional IRA
  7. Reverse mortgage
  8. Credit cards
  9. 401(k) withdrawal
 
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    At the end of each quarter Morningstar Indexes publishes an assessment of the state of the market and the economy. The information/views shown in the commentary are those of Morningstar, Inc. and not that of Morningstar Investment Management LLC.
    Here's a snapshot from the 2012 Q1 Morningstar Market Commentary (indexes.morningstar.com):
    The U.S. market's fourth-quarter rally continued into 2012, with the Morningstar US Market Index rallying nearly 13% this quarter. The U.S. saw unemployment fall much faster than anticipated, dropping to 8.3% in February. Concerns about Europe, which have plagued the market for years, faded in the quarter as investors instead focused on the domestic economic recovery. Housing has shown some signs of improvement, but it is too early to tell if improvement is just seasonal or permanent. Meanwhile, bond returns were widely divergent during the first quarter. All major factors of attribution were in play: duration, interest rates, the yield curve, asset allocation, credit quality, sector rotation, economic fundamentals and volatility. The backup in treasury yields, especially on the long end of the yield curve, caused treasuries to significantly underperform corporates, and to a lesser extent, mortgages. The Morningstar Core Bond Index returned a meager 0.26% during the quarter, masking the large differences among the domestic sub-indexes.
Q1 2012 Morningstar Indexes
Stocks
US Market Index 12.87
Global Ex-US Index 11.30
Developed Ex-US Index 10.89
Emerging Markets Index 13.44
US Market Index 12.87
Global Ex-US Index 11.30
Bonds
Core Bond Index 0.26
Commodities
Long-Only Commodity Index 4.37
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