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Personal Financial Planning - Setting Up an Emergency Cash Reserve

Posted April 15, 2010

Topics: Finance & Investing

Some financial pros tell you to have six months' worth of income put aside. This is easier said than done. But you can create an emergency reserve in several ways short of saving up half a year’s income and then leaving it on deposit at about 1%.

Here are a few ways to set up your cash reserve:

1. Home Equity Line of Credit - This is a wonderfully convenient type of second mortgage, but a very dangerous one. It is all 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. It happens too often that people move their credit card debts to the line of credit and then replace the credit card debt, a disastrous course. This is a great vehicle for available cash, and interest is usually tax deductible, unlike the higher interest you pay on your credit card balances. But it is only worth considering if you can be very disciplined. It has to work as an emergency reserve fund, and not as “found money.”

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 much harder to pay it off. A potential problem with credit cards is that some issuers are reducing lines of credit and even canceling 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 truly emergency lines of credit, and don’t keep them in your wallet or purse. Bring them out only when a true emergency strikes.

3. Found money - Do you have an inheritance, bonus, lawsuit settlement, or other sources of unplanned wealth? If so, don’t go crazy and spend all of it at once. Set up that emergency reserve and create a nice cushion for yourself. Where? Some good places to park “extra” cash are in higher than average dividend yielding stocks, but only in exceptionally 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 market in both bull and bear times.

In summary, managing money is like all good habits. It’s easy to define what is a smart course of action but much more difficult to follow the good advice. 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. I was once told that the second million dollars is easier to get than the first million. So my plan is to work on the second million now, and go back later to get the first million. Sounds like a plan …