6
The Contingency Fund
There is no new suit of clothes, no vacation, no new car that can offset the pain of being truly worried about running out of money.
Ben Stein
The edge is a miserable place to live. People who exist from paycheck to paycheck know this. They spend all they have. And when something unexpected happens, they must run to the credit cards, the finance company, or worse, the bankruptcy court.
The antidote to living on the edge is simple. Move away! It starts with a single step away from the edge. Follow that with another and another until you have created enough space between where you live and the edge so that you can relax—and sleep at night.
I know you are anxious to get to the “good stuff” in the next chapter—the part where you are going to get out of debt (yes, you are!). But there is a very good reason why you need to read this chapter first. If you start focusing on how you are going to get out of debt rapidly, you may decide to speed up that process. In fact, it will not surprise me if you get so excited that you decide you are going to complete your debt-free plan in half the time. But wait! That may not be such a great idea.
Let’s say you devote every dollar you can find to get out of debt fast—to the point that you refuse to save even a nickel. I suppose it makes sense on some level that if you are in debt you shouldn’t keep anything for yourself until your creditor is repaid. But that is very foolish!
What will you do if something big happens while you are repaying that debt at lightning speed? If you have no savings, no Contingency Fund, nothing put away in case of an emergency, what will you do when you get laid off or your car dies? You’ll be right back where you were before you picked up this book, running to credit cards for a bailout.
You need to decide right now that you are going to get out of debt the right way, the sane way, and the prudent way. And that, my friend, means you must start saving money—even if it is just a small amount to start, even if you are deeply in debt, even if you are so anxious to get out of debt that you can think of nothing else. We are going to get to that in just a few more pages, but first you need to meet your new best friend.
The Contingency Fund
What puts distance between you and the edge is called a Contingency Fund. It is a tangible hedge of protection. It is a pool of money available to you at all times on which you can get your hands in a short period of time. Your Contingency Fund will be stored in a safe place that pays at least enough interest to stay ahead of inflation.
A Contingency Fund has nothing to do with your retirement savings or investments. It is not the money you put aside to pay for unexpected, irregular, and intermittent expenses—expenses that do not occur on a monthly basis and have a way of catching us off guard (we’ll talk about how to handle these expenses in chapter 8). A Contingency Fund is not for discretionary spending. It is money set aside for major catastrophes, when your only other recourse is to run for credit. It will be there if you lose your job or if your safety or health is at risk.
Financial experts typically suggest that a family needs the equivalent of three to six months’ living expenses in reserve. I find that recommendation somewhat nebulous. How much money is that? We need a dollar figure.
I have no idea how much money you would need to survive for three months without a paycheck. You would have to pay your basic bills and keep food on the table, gas in the car, medicine in the cabinet, and so on. You would likely go on quite a spending diet while hopefully receiving some amount of unemployment benefit. So you can see there are many unknowns.
For our purposes here, let’s set an arbitrary figure of $10,000 for the average family. It’s a nice round figure. But please keep in mind that you could need much more, or possibly less. If your monthly expenses are high, you should adjust the amount to cover what you would need to live for a full three months without any income.
Think of your Contingency Fund as your personal debt insurance. Its short-term purpose is to give you an alternative to using credit to cover emergencies such as medical bills for which you are not otherwise prepared.
Eventually, your Contingency Fund will become your second line of defense against debt (see chapter 8 for the Freedom Account—your first line of defense). Once your Freedom Account is in place, the Contingency Fund has one primary purpose: to be the bridge you will need in the event you and your income temporarily part company. It is difficult enough to get out of debt, but if you are continually adding new debt, it becomes nearly impossible.
Creating Your Contingency Fund
If you have no savings at this time, you may have already concluded there is no way you will ever be able to save $10,000. I understand. But remember the salami. You cannot save $10,000 at one time, but you can start with $1.
The second “10” in the 10-10-80 formula is the money with which you will begin building your Contingency Fund. Ten percent of everything you receive from now on goes straight into that. I am not kidding when I say you can start with $1. There is even a bank I will tell you about in a bit that will allow you to open a savings account with $1. So no excuses, okay?
The goal is to accumulate and then maintain a $10,000 Contingency Fund as your normal way of life. If you find it necessary to withdraw money from your fund, it should be replaced as quickly as possible—becoming your top savings priority until it is restored to a full $10,000.
Maintaining Your Contingency Fund
You will be tempted to start seeing your Contingency Fund as a long-term investment. Avoid doing that, because this isn’t an investment. It is money that is available to you in an emergency. It is insurance that will keep you afloat. When looking for a place to park your Contingency Fund, you need to be concerned about safety, availability, and growth—in that order.
· Safety. Your Contingency Fund must be in an account where the principal is not at risk. This is why your Contingency Fund should not be invested in the stock market.
· Availability. Because of the nature of emergencies, this fund needs to be liquid—meaning you could get your hands on at least part of it within twenty-four to forty-eight hours.
· Growth. You will be maintaining your Contingency Fund for many years. As a good steward, you want to expose it to the best compounding interest available, with no fees if possible, while still meeting the safety and availability requirements.
Whether you have no savings now or have a great start on accumulating at least $10,000, you’ll want to start thinking about where to keep your Contingency Fund.
CREDIT UNIONS AND BANK ACCOUNTS
Banks are for-profit corporations, while credit unions are nonprofit organizations that exist for the benefit of their members. When a credit union generates a surplus, it is paid out to account holders in the form of either a small dividend or a rebate of loan interest at the end of the fiscal year. Typically, credit union fees are lower, while their interest rates are a bit higher. To find a credit union you can join, go to CreditUnion.coop and click on “Locate a Credit Union.”
When you walk into a bank or credit union to open an account for your Contingency Fund, you’ll be given a choice depending on your opening deposit that may include the following:
Bank money market accounts. Don’t confuse these with money market funds that are offered by mutual fund companies. Bank money market accounts carry the same federal insurance provision as other bank deposits, but they typically pay lower interest than a money market fund.
Certificates of deposit. These are similar to a passbook savings account in that you deposit the money and are paid a set rate of interest. The difference is that, in exchange for your promise to leave the money for a set period of time (90 days, 180 days, 1 year, etc.), you are guaranteed a higher rate of interest. If you must withdraw early, there is a penalty that will apply to the interest portion only. The penalty will never touch your principal. If you take a short-term CD, you will receive slightly less interest.
ONLINE SAVINGS BANKS
These are not like regular banks that you walk into. They are online and operate via the internet. Once you open your online savings account, it is linked to your current checking account, no matter where you have that account.
You can open an online savings account either online or by mail, and you can set up automatic deposits and have access to your account 24/7. These online savings banks do not have the overhead and operational costs of other banks and pass the savings to their customers in the form of no fees, no minimums, and excellent interest rates. And they have no required minimum balances. You can open an account with just $1.
At this writing, interest rates are abysmally low no matter where you park your Contingency Fund. However, online banks offer rates that are higher than the rates you will find at the typical walk-in bank or credit union. Here are a few options for an online savings bank:
Sallie Mae Bank. The savings rate is 0.90 percent APY, with no fees and no minimum. Salliemae.com/banking is FDIC insured.
Smarty Pig. The savings rate at this very fun, FDIC-insured online savings bank is 1.00 percent APY, with no fees and no minimums. See SmartyPig.com.
Wesleyan Investment Foundation. The savings rate here is 1.00 percent APR for a total principal up to $4,999, 1.50 percent for balances $5,000–$34,999, and 2.00 percent APR on balances $35,000 and up. This investment foundation is not FDIC insured, but there are no fees on savings accounts. See WIFOnline.com.
Ally Bank. Savings accounts here have no fees or service charges and currently pay 0.85 percent APY. See Ally.com.
ALTERNATIVE PARKING PLACES
While the following options are not quite as convenient to access as the accounts I’ve mentioned above, I would be remiss if I did not include them.
Treasury bills. The minimum investment required is $1,000. Government securities are sold at auction, and there is a process you will need to learn to become an active participant. The benefit of having your Contingency Fund in Treasury bills is that you will not be tempted to spend your money mindlessly because of the additional effort it takes to cash them in.
Money market funds. A money market fund (not to be confused with a money market account at a bank) is a large pool of money managed by professionals and invested in safe and stable securities, including commercial paper (short-term IOUs of large US corporations), Treasury bills, and large bank CDs. Money market funds are a very attractive place to grow a Contingency Fund because of:
· Safety. Even though not guaranteed by the federal government, this type of account is regulated by the Securities Exchange Commission.
· Liquidity. Deposits are not tied to any time frames, which means your funds are available at any time and in any amount. You can take out only the amount you need.
· Higher rates of interest. The return on money market funds is typically 1 to 1.5 percentage points higher than on bank or credit union accounts.
· Check-writing privileges. This feature allows you access to the funds in your account without having to go through phone calls and wire transfers. But you cannot think of this as a checking account, and that’s good. Money market funds have restrictions against writing checks for small amounts, say less than $200. Typically, there are no fees imposed or restrictions on the number of checks you can write in a month.
If your funds are parked in a money market fund, you don’t have to worry about maturity dates, the possibility of early withdrawal penalties, or getting in before the auction closes. The interest effective yield (interest rate) moves with the general state of the economy.
While most money market funds require a minimum deposit of at least $2,500, some waive that requirement if you authorize automatic deposits of at least $50 a month. Be certain to inquire about such a provision.
There are literally hundreds of money market funds from which to choose if you decide this is a good place for your Contingency Fund. Before opening any account, you need to call for and read a prospectus so you fully understand the rules and risks involved. With the prospectus you will receive an application that looks daunting but is actually quite simple to complete. If you have any questions, you should call the toll-free customer service number.
AUTOMATIC DEPOSIT AUTHORIZATION
I am a big proponent of automatic deposits, especially when it comes to building a Contingency Fund.
With my busy lifestyle and my tendency to put things off, I know I would forget or find some reason to skip my savings deposits from time to time. Authorizing my bank or investment account manager to reach into my checking account on a specified day every month to take out the amount I authorize is one way I simplify my life. In a way, it’s like delegating work to someone else so I can be free to do what I do best. I think of it as hiring a staff person to handle the savings and depositing that I’ve committed to do.
If you have any tendencies toward procrastination and feel better when things are taken care of for you, I suggest you think seriously about arranging for automatic deposits into your Contingency Fund. Even more important than knowing you won’t have to remember to make the deposit is that if the money is gone before you see it, you won’t miss it. I’ve proven this for myself and have had it confirmed over and over again by people who have tried it.
In the beginning, you might feel the pinch of having your savings automatically deducted from your regular checking account and deposited into your savings vehicle. But before you know it, this will become ordinary. You won’t miss the money, and you won’t have to worry about remembering to make the transfer of funds. Some larger employers offer such a service as a payroll deduction plan. You simply fill out an authorization form with the specific account numbers, and your pay stub indicates that the money has been deposited automatically. Of course, you can change your automatic deposit authorization at any time. You can increase the amount, change the date, or even change your mind. You’re the boss, and that is a wonderful feeling!
Once You Reach Your Goal
The day will come—and sooner than you think—when your Contingency Fund reaches the goal you have set. So, you may be asking, can I stop saving money then? No, never! Always and forever you must pay yourself 10 percent.
Think back a moment to the debt-proof living formula: 10-10-80. I told you this is a formula you should follow for the rest of your life for managing your money. But you are right. You will not contribute to your Contingency Fund indefinitely. That would be foolish, because as I said before, it is not an investment account. It is an industrial-strength emergency fund. But let me back up just a bit to allow you to see a bigger picture.
The debt-proof living plan is divided into four savings levels. You will learn more about this in chapter 9, but I will tell you this much now. Savings level 1 is where you create and build your Contingency Fund to the goal you have predetermined for your specific situation—enough to live on for six months without a paycheck or at least $10,000.
Using Your Contingency Fund
As with any kind of emergency preparedness, like a first-aid kit or emergency food and water in case of an earthquake or hurricane, you don’t look forward to needing it. But if an emergency happens, you are thankful to be prepared. The same is true for your Contingency Fund. Once you have saved and put away the cash, you will not find it easy to dip into it. That’s good. Remember, this fund is not to tide you over until next payday or to buy a new sofa. Your Contingency Fund is for life’s big financial challenges: unemployment or other financial surprises that could throw you off course such as a medical emergency.
If you hit a rough spot in the road of life and are compelled to draw from your Contingency Fund, it is important that you think of it as giving yourself a loan and that you pay it back as quickly as possible to get your Contingency Fund back to fully funded status. How? The same way you built it: by sending 10 percent of your net take-home pay straight to your Contingency Fund.
Do you see what is happening here? Instead of looking to credit cards, parents, or some other source of lending when you face an emergency, you become your own bank. Your Contingency Fund and money-management skills allow you to fund your own emergencies without any need to apply, plead, or pay fees or interest—to say nothing of the stress a financial emergency can create.
This Is a Must
No matter your situation—even if you are up to your eyeballs in credit card debt—you must have a Contingency Fund.
Your attitude about your Contingency Fund will either make or break it. If you see it as a pool of money to be used at will for anything that suits your fancy at the moment, you have completely missed the purpose of a Contingency Fund.
A Contingency Fund creates margin and allows you to step away from the edge. Money in the bank changes everything.