Unfortunately, emergencies are often unavoidable, and there’s a good chance that many of us will at some point experience an emergency that requires us to pay a bill we hadn’t factored into our budget.
The best advice for life’s unplanned costs is being prepared with an emergency fund
. Keep in mind that a credit card
is not the best substitute for an emergency fund. Using a credit card to fund an emergency should be used as a last resort, as it could cause you to rack up interest charges or late fees if you cannot pay off the balance on time
. Late payments and high credit card balances can also chip away at your credit score
, making it harder and potentially more expensive for you to secure financing when you need it down the road. There are similar considerations with taking out a personal loan to cover emergency expenses. An emergency and its unexpected costs are difficult enough to begin with - you don’t want to make the financial situation worse by piling up debt
Have a Plan
Emergencies come in all forms. Medical issues
are among the most common, as are job losses, vehicle breakdowns, or a household disaster like broken pipes or a furnace dying in the middle of winter. Due to the fact that any emergency can have a potentially large price tag, it can be helpful to develop an emergency cost plan
to get a baseline regarding how much money you have coming in and where you can slash spending to free up some funds. This way, when you have unexpected bills in front of you, you have an idea of what your options are instead of starting from scratch. Trying to come up with money while you are in a state of panic will likely add stress to an already overwhelming situation.
When money is tight, it can seem impossible to build up a significant emergency fund. However, changing a few spending habits here and there can help free up funds for your savings account
without causing financial hardship. Try saving all of your change, or your low denomination bills, such as $1 and $5 bills, and deposit them into your savings account. Another tip is to create a budget
so you know exactly where your money is going so you can determine what you can realistically cut back on. Put aside any unexpected funds you receive such as tax refunds or cash gifts. Rather than spend it, use it to build up your emergency fund or pay off bills or credit card balances you may have from a past emergency.
It is often recommended that an emergency fund contain between three and six months’
worth of income. Therefore, to create a plan, you should calculate what 3-6 months’ worth of income looks like for you. This will give you a good idea of how much money you should set aside for an emergency. Obviously every emergency isn’t going to cost you that much, but it’s a good idea to plan for the worst case scenario - for example, being out of work for 6 months due to a layoff or injury.
Paying for Emergencies without an Emergency Fund
Unfortunately, emergencies will not wait until you are able to build up an emergency fund. Here are some options to consider if you experience an emergency that requires fast access to cash:
• Other Savings Accounts. The first option to consider is any other savings accounts you may have. Many people have one or multiple savings accounts that they use for specific financial goals. Maybe you are saving for your child’s college education, putting money aside to buy a home, or saving up for a luxury vacation. While it may be heartbreaking to have to put some of your financial goals on hold, pulling money from your existing savings accounts could be your best option for covering unexpected costs without racking up debt and accruing interest.
• Roth IRA Fund. If you have a Roth IRA that you’re using to save for retirement, you may consider using it as a sort of “alternative emergency fund”. Unlike some other retirement plans, a Roth IRA allows you to withdraw your prior contributions without incurring penalties or additional taxes, as long as you have held the account for at least five years. This is among the best sources of fast cash for those without a substantial emergency fund, but requires you set up your Roth account early on, and consistently contribute to it, in order to qualify for an emergency distribution when needed.
• Health Savings Account. If your emergency is medical related, you may be able to pay for some of the unexpected costs using a Health Savings Account (HSA), if you have one. Another benefit of an HSA is that if your emergency involves the loss of your job, all of the money in your HSA is still yours. You could potentially use your HSA to pay your health insurance premiums or other eligible medical expenses while you’re unemployed, so you don’t have to pay out of pocket.
• 401(k) Withdrawal. Many 401(k) plans allow you to withdraw funds if needed, and repay them later. Although this is considered a “loan”, you are accessing your own money you have built up for retirement. As you repay the loan, the funds are used to rebuild your 401(k) account balance. If considering a loan from your 401(k), it’s important to fully understand all of the implications regarding taxes, and what happens if you fail to repay the loan. In some cases, you may be eligible for a 401(k) hardship withdrawal, which does not need to be paid back, however you will need to pay taxes on the withdrawn amount unless you are at least 59 ½ years old, or qualify for an exception.
• Life Insurance Cash Value Loan. If you hold a permanent life insurance policy (not to be confused with a term policy), you can typically borrow against the cash value of it. Be aware though that interest charges on a life insurance loan are often very high, so some financial experts recommend only borrowing from your life insurance policy as a last resort. With this type of loan, you do not have to repay the borrowed amount, but if you do not repay it, the loan balance and accrued interest will be deducted from the death benefit, reducing the payout your loved ones will receive upon your death.
Although we don’t often like to think about things going wrong, planning ahead for an emergency is always your best bet. By knowing all of the options available to you, you can help ease the financial stress of an emergency, and make smart choices that won’t negatively impact your wallet down the road. For additional money management tips, visit the Bank5 Connect blog.