Financial Emergencies – part 1: 3 reasons you should plan for a rainy day

by Erik Garcia

It was a September day in New Orleans when I got the call from my wife, “The AC is not cooling the house!” It had to be totally replaced and it cost thousands. Thankfully we had some money set aside otherwise it could have been very uncomfortable. The reality is air conditioners break during New Orleans summers. You’ve heard it before…it’s time-tested wisdom, “Plan for a rainy day” (or I guess for me a “really, really hot day”!). If it hasn’t rained for you yet, it will and everyone should prepare themselves for it financially.

Emergencies can come in all shapes and sizes. Car repairs and the unexpected need for medical care seem to be 2 pretty popular emergencies. Some other common emergencies are the, “Oops, I forgot my kid’s tuition was due today!” and the “How much do I owe in taxes?…ouch…didn’t expect that!”

Setting money aside for that unexpected expense is one foundational principle to managing finances wisely. Here are 3 reasons why setting up an emergency fund is a prudent financial move.

Having an emergency fund:

Relieves stress. More than 1 in every 3 American Households (38%) live paycheck to paycheck (source: Consumer Federation of America 2012). There is very little margin for error for too many families. Knowing you have set money aside to cover something unexpected is comforting. For instance, having a broken AC during a New Orleans summer I imagine would be more stressful if I couldn’t get it fixed. Having that money set aside can also reduce arguments with your family which in turn reduces overall stress.
Prevents you from going into debt. If you do not have money set aside for an unexpected expense you may be forced to borrow the money, possibly use your credit card. And borrowing is expensive. According to Creditcard.com, the national average credit card interest rate is 15.01% and the average American household with at least one credit card has nearly $15,950 in credit card debt (in 2012). If you’re average, you could be paying over $2000 a year in interest payments alone already. Don’t add more!
Avoids potential taxes and penalties. To often I speak with people who have withdrawn money from their 401ks or IRAs to cover emergencies. Consider that if you are making an early withdrawal from your retirement account, you may be stuck with a 10% penalty on top of paying taxes. For example, assuming a 20% tax rate, if you take out $5,000 from your 401k pre-maturely, you may walk away with only $3,500 after taxes and penalties. To get $3,500 it cost you $1,500…not so wise. Having money set aside prevents you from accessing long-term money.

It’s only a matter of time before you are faced with a financial emergency. Are you prepared for a “Rainy Day”?