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Setting up your emergency fund.

This column is about setting up an "emergency fund," a term often bandied about, but seldom explained. It is explained here.

An emergency funds is a stash of money that is easily accessible in case of "emergency," such as a sudden illness, a layoff, or serious property damage. For exceptional parents, emergencies can also extend to medical and equipment expenses, as well as to related travel and overnight lodging expenses.

The basics

An emergency fund differs from investment assets because it is close to ready cash. Selling long-term assets to raise emergency cash can be costly. Although stocks and bonds are liquid, selling in down markets is a downer. It makes sense to keep some cash or near-cash (that is to say, easily liquidated) on hand.

At the same time, cash is not a good long-term asset because it has no earnings power. Therefore, we want to keep it to a minimum. inflation will erode, and eventually destroy, the purchasing power of cash. If you leave $1,000 in a coffee can, in 10 years, with five-percent inflation, it will buy only 634 worth of groceries. To offset the effects of inflation you need earnings that exceed it. If inflation is at five percent, you need an earnings rate of five percent just to stay even. Unfortunately, once you have earnings, you must pay taxes. When you put inflation together with taxes, you have taxflation -- a real drag. So much of a drag that, if you are in the 28-percent tax bracket and inflation is five percent (the case over the last 20 years), you must have investment earnings of 7.7 percent just to stay even!

Funding an emergency

An emergency fund must be liquid (easily converted to cash) and should also correct some interest. You might consider using an interest-bearing checking account as your emergency fund. A savings account will also do the job. Actually, any short-term fixed asset (which would include Treasury bills) will do.

However, some "do" better than others. The money-market account in a bank has check-writing privileges and is currently paying about 2.5 percent in interest. Money markets from mutual fund companies have check-writing privileges and are paying about 4.5 percent. The difference? The bank money-market account is insured by the Federal Deposit Insurance Corporation for up to $100,000. The money-market money market account is not.

Is the insurance worth the two-percent difference? Probably not. Mutual-fund money markets are funded with commercial paper. Commercial paper is short-term (one year or less) IOUs issued by major companies. If Ford has an extra $40,000,000 for 60 days, it lends the money to IBM, which needs $40,000,000 for 60 days. They charge each other a lower rate of, interest than the banks would. The mutual-fund money markets "hold" this paper. Although these funds are not insured by the FDIC, if they crash we will all be in the same bread line, so what's the difference?

How much should you keep in an emergency fund? It depends. Financial papers and magazines will tell you three to six months of living expenses. As a rule of thumb, it's not a bad start, but everyone has a different-sized thumb. In an emergency fund you should have what you need, but no more because of its low earnings.

An alternative to fully funding an emergency fund with cash is using credit. Using credit cards can be expensive, however. Credit-card interest is 15 to 22 percent. That means that if you keep the loan out for five years, and the rate is 20 percent, you will pay 100 percent in interest charges.

If you own your home, condo or co-op, your primary credit should be a home-equity line of credit because it is income-tax deductible. Your cost of borrowing is reduced by your tax rate. An example of the cost of borrowing on a home-equity line of credit: Lenders are currently charging around 10 percent for home-equity lines. That means, if you are in the 28-percent tax bracket, your net cost of money is 7.2 percent (100 -.28 =.72). Borrowing may be cheaper than liquidating long-term assets.

In summary: everyone should have an emergency fund of ready cash "just in case." The fund should be in an interest-bearing account or available in the lowest-cost credit account. The amount in that account should be calculated by your individual situation.

This column is the final of a four-part series on Risk Management:

* April: Risk Management: How big is your life boat?

* May: Corporate Disability

* June: Shopping for Personal Disability Insurance

* July: Setting Up your Emergency Fund
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No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Risk Management, part 4
Author:Neumann, Randy
Publication:The Exceptional Parent
Date:Jul 1, 1997
Words:770
Previous Article:The NPA on family-centered perinatal care.
Next Article:Alternatives to the Uniform Gifts to Minors Accounts.
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