Before moving through this article regarding our “Rainy Day Fund,” why not review what we have done up to this point.
- We created a budget that gives us an idea of where we are earning our income as well as where we are spending our money. This simple process has shown us whether we are accumulating wealth in the form of savings or spending more than our income and thus generating additional debt.
- We have looked at the various types of debt that we currently owe. This is usually in the form of a mortgage, car loan or credit cards. Most households that are not renting have all three forms of debt if not more. Remember however, that our goal is financial security and we will get there. It starts with understanding where we currently stand and where we want to be.
Knowing our budget and our debt situation we can now work on saving up a rainy-day cushion in the form of a savings account as well as a checking account.
NOTE: Here our articles may not take on a perfectly linear order. If you need to work on cutting costs that article is to come. This article is really giving us a general basis for how much money we should have for emergency situations. This is a very important article to read, however, if you are able to save any money at this point read through this article but do not feel the need to implement it. Do not consider yourself behind if you are not ready to save for a “Rainy Day Fund.” We will get to that.
Moving on, no one can accurately anticipate the future. If we could I we would just put all our money in a single stock or put it on red or black at a casino. Because of this we need to have money that is “liquid” so that we can be prepared for a surprise change in our lifestyle.
Liquidity – The degree to which an asset can be converted to cash easily and quickly, with little or no loss of value.
In other words, if you have liquid assets in the form of cash or a savings account, you can access those funds quickly in the event that you must pay an abnormal amount out of pocket for what may be an unexpected expense. Unlike planning to purchase a car or a home these expenses are unanticipated and important to keep your health, home and perhaps transportation. Everyone has unexpected expenses; for example:
- A trip to the hospital or an illness that requires you pay some or substantially all the costs in cash.
- An expensive car repair outside of normal upkeep that you didn’t see coming.
- Cash that a close friend or relative needs immediately or in a short time frame.
- An emergency trip to help a relative for any various reasons.
NOTE: A paid vacation or a new car purchased out of desire is not a surprise event. These would be items that you save for in the future.
If you have an amount of cash that is “liquid” then you can access that cash quickly to cover these unexpected costs. Below in Figure 1 is a brief hierarchy of your most liquid assets. A key distinction here is that we are listing assets. In addition to assets, you may also have credit cards you can draw on if you are not at your limit as well as other loans you could obtain. However, in an ideal scenario you would not use these for immediate cash needs because you have some cash available. Again, below is just a list of your most liquid assets. For ease of use we will assume you own your house outright, I know, not the case for most of us but we are working on a concept here. At the top we have assets that can easily be converted to cash, towards the bottom we are starting to list assets such as home goods, a car or even your house. The items towards the bottom could be sold, however, selling these assets would most likely take longer and if you attempted to sell them quickly you would probably have to accept less money than they might be worth.
Our focus now is on our liquid assets. We want to have a certain amount of cash or assets that are easily converted to cash for two main reasons.
- We lose a source of income. In this case we need to ensure that we have enough money to live for the short to medium term timeframe.
- There is an unexpected expense that is not in our normal budget but that is important or necessary for us to maintain our standard of living in the short to medium term.
The general rule of thumb that is often mentioned is that we should have cash on hand for approximately six months of living expenses. This can be slightly more or less depending on your other assets and circumstances that are outside the scope of this article. The goal is that we can live for a reasonable period (six months), of time if we do lose our job or main source of income. We want to ensure we can afford our home, car payments, health premiums, utilities and other miscellaneous costs so we do not become destitute, or out on the streets.
The good news is that this is simple because we have already made out budget. Look at your total monthly expenses from your budget and simply multiple those expenses by six. The most common place to hold this money is in a savings or checking account that you can access immediately. So, keep that amount of cash in very liquid assets.
Now we are in a better position than many people in the world. We have enough of a cushion that we can, with relative safety, live within the budget we have gotten used to for at least six months. If you have got through this step you are doing well. Now we can start to look at costs that we can cut which is the source of a lot of articles to come. What we do have though is a goal to work towards in terms of a safety net based on our current needs. Hopefully at this point you are starting to get a good picture in your head of your general financial situation.