Friday, February 03, 2006

Emergency funds for the broke

A classic piece of financial advice is 'build an emergency fund of six months' living expenses.'" Suze Orman argues that you need an eight-month fund. For many years, I looked at these sorts of recommendations and laughed. Six months of savings!? My paychecks were covering rent, food and enough fun to keep me sane. They were not big enough to do much of anything in the way of savings. Six months of savings is simply not happening on an entry-level journalism salary.

But the young and broke can still have emergencies, and it’s a good idea to have some backup systems in place for handling them (beyond the traditional twentysomething backup -- "um, hi mom ..."). One of the best pieces of financial advice I heard during the run-up to the dot-com meltdown, when everyone I encountered in "Silicon Alley" worried about how long their company had left before it collapsed, was: get a credit card with a high enough max to float you for several months. Make that your emergency fund. Lock it up where you can't easily touch it, but get it now, while you still have the job and the income to procure high credit. (Obviously, this is not a good plan if you don't trust yourself with credit -- I wouldn't advise giving a high-limit card to a college student, f'rinstance. I think it's a lot harder to be sane about credit before you have regular paychecks and get a better sense of what it's like to work within finite financial resources.)

And don't worry about 'too much credit' hurting your credit score. Applying for a flurry of new credit can affect your score, but simply having a copious amount of unused credit doesn't hurt you at all. It can actually be good for your score, since lenders do pay very close attention to what percentage of your available credit you're using. Having $4,000 used of $5,000 in available credit will set off red flags; having $4,000 used of $20,000 in available credit will impress. When Amex spontaneously added $10,000 to my credit limit, my FICO score jumped 20 points in a month.

Obviously, a credit card isn't an ideal emergency solution. But if you're broke, and especially if you already have credit-card debt, it's a much better idea than trying to squirrel away cash that could instead be going to pay down high-interest debt.

With one exception: like most people, I'm a big advocate of taking advantage of company 401k matches. Even if your company doesn't offer a match, putting some money aside in a 401k is a good idea, since you at least get the tax-savings benefit. If your employer does offer a match, though, take the free money, even if it means paying off debt a bit more slowly. Because 401ks also make great emergency funds. Most plans allow you to take a loan of up to half your balance for pretty much any reason, and if you get really desperate, hardship withdraws are an option. They carry nasty penalties and tax repercussions, but in a genuine emergency, 401ks are at least a tangible asset you can tap.

While I've been emergency-fundless till now (building one is my plan for 2006), it hasn't worried me overmuch because I always knew that if I lost my job or otherwise suffered catastrophe, my 401k would keep me from imminent rent-check-bouncing homelessness.

Not a moment too soon, either. In the past two months, David and I ran into the first genuine financial emergencies we've had -- a sudden trip home for a funeral (a pricey proposition when "home" is Australia), followed by an unexpected hospitalization. Amex is pulling us through till we can collect our tax refund. Yay IRS as emergency fund!