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Personal Financial Planning - Setting Up an Emergency Cash Fund

Posted May 19, 2011

Topics: Finance & Investing

Financial pros advise having three to six months' worth of income put aside for emergencies. You can create such a find in several ways without having to save up half a year’s income and then leaving it on deposit at about 1%.

Here are a few ways to get started:

1. Home Equity Line of Credit - This is a wonderfully convenient but also highly dangerous second mortgage. It is too easy to consolidate other debts and move them over to the HELOC. But remember, the interest rate is variable, meaning it could easily go up in the future. People move their credit card debts to the line of credit and then replace the credit card debt, a disastrous outcome that keeps you in debt far into the future. This is a great vehicle for available cash, and interest is usually tax deductible, unlike the interest you pay on your credit card balances. But it is only worth considering if you can be disciplined about how you use it.

2. Zero balance credit cards - like the home equity-based credit line, the credit card line of credit can be used for emergencies. It also comes with a great amount of danger. It is easy to max it out, but harder to pay it off. A problem with credit cards: Some issuers reduce lines of credit and even cancel cards, even if their customers have a perfect record; there are no guarantees your line of credit will be there next year or even next month. So if you have zero-balance cards, think of them as emergency lines of credit, and don’t keep them in your wallet or purse. Bring them out only when a true emergency comes up.

3. Found money, such as an inheritance, bonus, lawsuit settlement, or other sources of unplanned wealth. Don’t spend all of your windfall at once. Set up that emergency reserve and create a cushion for yourself. Where? Some good places to park “extra” cash are in higher than average dividend yielding stocks, but only in very well managed companies; higher than average CDs or other savings, which are tough to find these days; or a no-load mutual fund with at least a five-year track record of out-performing the averages in both bull and bear markets.

Managing money is easy to define but much more difficult to act on. Think of savings like dieting. If you splurge, you pay for it later. With a diet, that means sweating through exercise and watching what you eat. With money, it means pretty much the same thing: sweating through self-imposed budgets and cutting out the extra stuff.

Maybe a better solution is to just get rich. Once you figure out how to do that the easy way, let me know how too …

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE blog and to the Seeking Alpha blog.