We are probably already living in the longest recession since the great depression of the late 1920’s and early 1930’s. Many people have lost jobs; many large and small businesses have gone under; it’s difficult to get credit which many were so dependent on and need the most now. For many people like me this is the first recession they are seeing and things have been tough.

Now, I did not intend to scare you by saying all this but it is such difficult times that get us thinking on how could one prepare for such a situation if it was to happen again or still continue to worsen? How one could avoid the adverse effect of such a situation on their finances and wealth?

I read, discussed and pondered and then it struck me that we all knew the solution all along, but probably due to the economic prosperity we have seen in the recent years, one did not give these lessons enough importance. If only we re-learn these five lessons…

Buy a home that you can really afford.

Home ownership is touted as ‘The American Dream’. While home ownership has many advantages, buying a home is a big decision which if gone wrong can have several negative consequences like foreclosure, bankruptcy, etc. If you qualify for a mortgage it does not necessarily mean you can afford it. Buy a house for which you can comfortably afford to pay the monthly mortgage payment for throughout the duration of the loan and not just a teaser rate for the early years.

Build an Emergency Fund.

An emergency fund is like a safety net you can build to insulate yourself in case of any unfortunate events that may happens in your life. When we have a steady source of income we tend to ignore this and assume that things will continue to be smooth.  Some people depend on their credit cards limit for their emergency fund but it is not certain you will have it when you need it. Your credit line may be reduced or worse the credit card company may go under. One should also learn how to invest the emergency fund.

Stock market investment is not for everyone.

Historically stock market returns have been better than many other investments that are easily accessible but there has been significant volatility in their returns in the short run. Any money you need in the near future say 5 years (may be for college tuitions, travel, buying a home, medical expenses, etc.) should not be in the stock market. Passive investment in stock market (aka index funds, mutual funds) can also lose a lot of money (The stock market had tanked more than 50% in the eighteen months leading to March 2009).

Do not over invest in your company’s stock (or sector).

So let us say you worked for Chrysler/Lehman Brothers and also had a significant portion of your investment in their stock (normal accounts or via retirement savings accounts like 401K), what could happen? Your job may be in danger and a significant portion of your investments would have been wiped out, even worse, if you are close to retirement that savings could be your life’s hard work. I guess you see the point.

Frugality

A word that had some negative connotation associated with it has gained some popularity now. More and more people have started seeing the value in saving money for the future, trying to spend on necessities than luxuries and living within your means have become the ‘in thing’.

This is a two part post covering the following topics.

Part 1:

What is an emergency fund?

Why do I need an emergency fund?

How much do I need to save?

Part 2:

How to get started?

How to invest your emergency fund?

What are the common pitfalls of emergency fund and how to avoid them?

How to get started?

So you know how much you need in emergency funds, but do you have that much allocated?

If you are well covered, then that’s great. That is like a landmark achievement in your personal finance history…! Now you can feel more comfortable to face any surprises life may present you with however if the number you came up with overwhelms you, don’t get worried, now is the time to start to achieve that number.

If possible you should devote most of your savings in the next few months towards building your emergency fund. If that is not possible or that will not be enough, start small, say by saving 10% of your salary, by not eating out for some time or by cutting down on your daily addictions, whatever works for you and helps you save a little extra, even if its $10-20 a week. Eventually you will find ways to save more or earn more.

• Transfer these savings in a separate savings account or a designated checking account on a regular basis. This is very important. If you do not separate out the money, you may not be able to save more.
• Do not use the money in this account for any other purpose but an emergency.
• Keep setting small achievable targets for increasing the funds, if you miss the target think about cutting back on some of your regular expense to cover up for it.

How to invest your emergency fund?

Congratulate yourself for coming to a stage where you can think about investing your emergency fund.  The key here is to keep your money accessible. Putting it in a designated high interest savings account or a designated high yield checking account is a good idea. This will help your emergency fund grow passively and you can focus on other financial goals.

Only if you have saved more than what you came up with as a number you need for your emergency fund you should consider other investments.

What are the common pitfalls of emergency fund and how to avoid them?

Resist any temptations to invest this money in stock market or mutual funds. Although they may be a good long term investment, they are very volatile in the short term and can lose you substantial amount of money. It gets even worse in times of economic turbulence when many people lose their jobs as well as take a huge hit in their savings which they had intended to use in case of emergencies.

Avoid putting these funds in long term certificate of deposits (CDs) as they are not very easily accessible and you may have to pay penalties to en-cash it before they mature.

Another common pitfall is that you may have created an emergency fund some time back and forgotten about it but as the circumstances in your life change, the amount of money you need in your emergency fund also change. So keep monitoring the amount you have in your emergency fund.

Rebuild your emergency fund as soon as possible after you have used some or all of it for an emergency. If you faced an emergency you would have realized how well this emergency fund served you, so if you have to; get started all over again.

Keep coming back to see tips some tips on how you can accelerate your savings and earn a little extra.

This is a two part post covering the following topics.
Part 1:

• What is an emergency fund?
• Why do I need an emergency fund?
• How much do I need to save?

Part 2:

• How to get started?
• How to invest your emergency fund?
• What are the common pitfalls of emergency fund and how to avoid them?

What is an emergency fund?

An emergency fund is the money you set aside to use when life presents you with unfortunate and unexpected events.

Simply put, emergency fund is the money you save in an easily accessible account so that it can be used to cover up for some expenses which you did not foresee or budget for; like a breakdown of your heating system, major home or car repairs or more unfortunate circumstances like job loss, major medical expenses, disability, accidents, etc.

Why do I need an emergency fund?

While I hope none of these events happens to you but none the less if you do make an emergency fund you will be in a better financial position to handle such an event. Many people seem to underestimate the chance of them having to face such a situation, especially young people, so if you are one of them, think again; Ask yourself, do I have enough saved up to cover for my expenses for some months in case of an emergency?

There are some psychological advantages to know that you have your back covered in unfortunate times, this will really help you live in a better way by relieving some of your stress.

It is very important, considering the critical nature of these funds I would recommended building an emergency fund over any kind of debt (even credit card debt, you heard me right…!).

How much do I need to save?

Unfortunately there is no magic number here but these guidelines should help you come up with your own number.

1. Calculate your regular expenses. Your regular expenses should include things that you generally spend on, on a regular basis. You could take an elaborate way to fund this out (like the one described here) but a back of the napkin approach works well too. Just add up the following:
   • Your monthly mortgage payments/rent and car loan payments.
   • Your monthly cost of insurance.
   • Monthly cost of essentials (groceries and travel).
   • Monthly miscellaneous expenses, like entertainment, shopping, etc. Your credit card (or debit card) statement should come in handy here.
2. On average you should save enough to cover up for about three to six months of regular expenses. This should help you in cases like job loss or a temporary disability.
3. You regular expenses will be higher if you have dependents that you support.
4. In general you will need more in emergency funds if you have more responsibilities and obligation to take care off. Just be sure to include all such expenses and then add a reasonable buffer on top of that.
5. Also make a list of expenses that you could quickly get rid off in an event like a layoff, say if you are an iPhone user, you could drop the data plan, or get rid of the extra channels in your cable connection. This might just come in handy. You do not have to write it down; just keep it in your mind. In general the more expenses you can cut down in case of a financial emergency the lesser you will need in emergency funds.

Part 2 here.

PS: This post is featured in the 209th Carnival of Personal Finance published at Living Almost Large

There are many resources like book, websites, courses, newsletters, etc on personal finance that teach you the methods of success in personal finance. These methods may be good and also practical but they may not necessarily be the best for you. You will always have to tweak them to suit your personal situation. No wonder it is called ‘Personal’ Finance and not ‘Generic’ Finance.

Principles are few; Methods are many.

The art is to master the principles and then apply them to your own situation and make your own methods. An opportunity lasts only for a while before it is public knowledge. Once it is known by all, it will quickly vanish; this makes it even more essential that you are always trained in principles not methods.
Here are the simple principles of personal finance:

1.Spend less than what you earn or earn more than what you spend
2.Make your money work hard for you.
3.Prepare for the unexpected
4.Take control of your money, career and destiny.

In some following articles I will walk through how you can apply these simple principles of successful personal finance to your methods.