Magazine article The Exceptional Parent

Setting Up Your Emergency Fund

Magazine article The Exceptional Parent

Setting Up Your Emergency Fund

Article excerpt

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. …

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