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E) BUILD AN EMERGENCY FUND
Building an emergency fund is an immediate and top priority. Many consumers do have an emergency fund and find it difficult to find the way to save extra money. However, a cash reserve is vital to financial health. A cash reserve helps prevent the consumer from accumulating a greater debt level during a crisis. A cash crisis can be caused due to loss of employment or other unexpected events such as car or home repairs. The consumer should not want to use a credit card in an emergency unless the bill can be paid off in the next billing period. Otherwise, by the time the consumer pays the interest, which grows daily, he or she can easily end up spending more than double the original cost. An emergency fund should equal three to six months living expenses and should be kept in cash or a in a savings account. The consumer should try to treat the emergency fund just like a bill. Pay into the emergency fund account every month or every two weeks. Stashing money in an easy access money market account takes discipline. Once you deposit your paycheck into your account there are often so many demands placed on you that it is hard not to spend it. You need to make a disciplined effort to pay your emergency fund first and not touch it for anything less than an emergency. An emergency is not those new shoes or new DVD that you want. The best examples of emergencies are necessary car repairs or bare bones living expenses when you lose a job.
Many Americans live paycheck to paycheck. Many Americans likely believe that it is very important to keep at least three months of living expenses on hand. However, far less people actually do keep an emergency fund equaling three months of living expenses on hand. It is easy to have serious financial problems caused by one catastrophe or mistake. Everyone wants to maximize the earnings on their savings. However, this desire must be balanced with the need for easy access to your money. For your emergency fund a good strategy is to keep a low yield-low risk savings account. This allows easy access to the money when it is needed. Some experts recommend building an additional contingency fund to support your self and family in case of job loss. This fund should also be kept in a low risk account with easy access.
Building any fund is a process that should take time and discipline. Discipline becomes easier over time and after the repetition of placing the money away each week. After building a fund that consists of at least two months of living expenses, it is a good idea to place some of the funds into a slightly longer-term savings or CD account. A three-month account is usually safe to set aside. This is a better strategy than to borrow from a 401 (k) or other retirement account. Roth IRA’s are also a good option to for the emergency funds. You are permitted to withdraw funds from a Roth IRA without any penalty.
Short-term investments such as savings accounts yield lower interest payments but provide the key factor for emergency funds, easy access with no penalties. Some investors prefer to invest in savings or other bonds. Although the interest rates are higher penalties for early withdrawal can be steep. There are ultra short-term bond funds that permit some flexibility. There is also less price risk in short-term bonds than in longer-term bonds because if interest rates increase a longer-term bond locks you into the lower rate for a longer period of time. Also, bond prices will fall when interest rates rise.
Tax-exempt investments are also good to consider. Individuals in higher income brackets often look to tax-exempt investments.
It is always advisable to find a level of risk that you are comfortable with. Experts recommend that the consumer should consider all options before making a decision on investing the emergency fund.
Early Withdrawal Problems
Although it is a good idea to keep your emergency fund in short term investments, there may come a time, due to the unexpected emergency, that you may need the cash. If your funds are held in a bond fund or a CD, cashing out early will likely cause you to pay early-withdrawal penalties. The bank should remind you of early-withdrawal penalties when you purchase a CD. Although many individuals focus on the interest rate and term of the investment, they do not consider the penalty, and loss of cash, if they need to access the cash earlier than anticipated. Federal law requires a minimum penalty of seven days interest for early withdrawal from time deposit accounts. There is no maximum penalty. Thus, banks will likely charge a larger penalty for early withdrawal. You can lose as much as six months of interest, or more, if you withdraw funds early from a long-term (2 years or more) CD. Both small and large banking institutions charge these stiff penalties because they are relying on you keeping the money in the account for the minimum required period.
Some banks will not clearly state to you the penalty until it is imposed. The penalty is usually determined by a formula based upon the maturity point of the CD. Thus, the earlier the withdrawal occurs, the higher the penalty to be imposed. Also included in the penalty determination is the market rate at the time the withdrawal occurs. In some cases the penalty exceeds the interest earned. Thus, for extremely early withdrawals the consumer may get back less than he or she initially deposited.
There are some exceptions to early withdrawal penalties. Penalties may be waived in cases where the accountholder dies or is declared mentally incompetent. Another option to investigate involves investing in high interest rate CD’s and setting them up for monthly interest withdrawal. Early withdrawal penalties may be deductible on tax returns.
Brokered CD’s are another option that can help the consumer avoid early withdrawal penalties. A brokered CD is through a deposit broker. This type of CD sometimes has no early withdrawal penalties. However, there is some risk. The deposit broker sells the CD on a secondary market. You must accept what the broker is able to sell it for. You risk getting less than what you initially paid for it. On the bright side, if you sell a brokered CD at a time when interest rates are lower than at the time you bought it you can receive a higher price for it. For example if you buy a brokered CD at 5% interest and sell it at a time when the highest rate for the same brokered CD is 4%, you will get a premium for the CD. The reverse is also true. If you buy a brokered CD when the rate is 5% and want to sell it at a time when the highest rate is 6%, then, with less demand for the CD, you may have to sell it at a discounted price. Thus, brokered CD’s can be a risky investment unless you intend to hold onto them.