4 ways to prepare for a financial emergency

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Don't be caught off-guard by financial emergencies
Building an emergency fund could take years. Here are steps you can take in the meantime.
From the Merrill Edge Minute e-newsletter.

Key points

  • Unexpected expenses or a job loss could undermine your finances, so it's critical to have a cash emergency fund
  • Amid competing priorities, saving enough to cover at least six months of living expenses could take several years
  • While you're building up your emergency fund, there are steps you can take that may offer you some protection
  • Get the checklist: View the checklist How to Create an Emergency Fund
Nobody wants to think about worst-case scenarios. Unfortunately, emergencies do happen, and your financial well-being could be undermined by outsized costs that might accompany an illness or injury, job loss or even a storm that does damage to your home.
Financial Emergency Preparedness
Learn more about the various steps you can take to help Learn about various steps you can take to help prepare for a financial emergency.
The best line of defense against such unexpected events is to have a liquid cash fund that can cover at least six months of living expenses or any large, unforeseen bills that are too high to pay out of your regular monthly income.
But you may not have saved enough in your emergency fund yet. After all, on top of daily expenses, you likely have competing financial goals such as Learn about saving for retirement, a child's education or a new home. At the same time you might be trying to pay down debt, and it can be difficult to prioritize how to allot any extra cash towards specific financial goals you have each month. This can make saving enough to have a buffer a gradual process. So, how do you help protect yourself and your loved ones while building your emergency fund?
Here are four moves to consider now, while building your emergency fund.

1. Think through how you might cut expenses quickly

If you lose your job or are faced with steep unexpected expenses but don't yet have a solid emergency fund, you might need to cut costs. Yet in mid-crisis it could be hard to think clearly about building a cost-cutting plan. Having this list prepared ahead of time could be a big help. Be willing to think big: A plan that rests merely on skipping lattes and switching to bagged lunches will only go so far. Consider contingency moves like these:
  • Figure out which non-essential services you could drop without triggering large cancellation fees — cable or a gym membership you're not using, for instance — and then if you find yourself in an unexpected financial emergency, cancel them as soon as possible
  • Sell your new car and buy a less costly and reliable used car
  • Replace expensive vacation plans with interesting and more affordable day trips instead
Going through this exercise may even help you find ways to economize now so you can use those extra savings to help build your emergency fund.
Be willing to think big: A plan that rests merely on skipping lattes and switching to bagged lunches will only go so far.

2. Make sure you have available credit

While you should be cautious about adding to your debt, having some credit available in an emergency could help see you through a rough patch if you don't yet have enough in your contingency fund. If you don't have a Learn all you need to know about owning a credit card, you could look into getting one now. You don't have to use it until you need it. Just remember:
  • Credit card interest rates can be high, so look for a card with the lowest annual percentage rate or best overall advantages for you
  • When using one, be sure to start paying off your credit card debt as soon as you can
If you own a home, it's worth understanding what home equity can do for you. Establishing a Learn all you need to know about a home equity line of credit (HELOC) now could also provide a ready source of emergency cash. While it shouldn't be your first line of defense, a line of credit allows you to borrow against the equity you hold in your home at an interest rate that's usually lower than that of a credit card. Note these caveats:
  • Money drawn from a HELOC is a loan, with your home as collateral, and it will increase your overall level of debt
  • You'll have to start paying the loan back right away
  • Credit lines can be structured in different ways but typically carry a variable interest rate, so be sure you understand all the rules before you sign up
If you own a home, it's worth understanding what home equity can do for you. Establishing a home equity line of credit (HELOC) now could also provide a ready source of emergency cash.

3. Understand the risks of relying on retirement accounts

Though tapping into your 401(k) or Learn about investing in a retirement IRA could be tempting if you need cash, remember that this could jeopardize your ability to stay on track toward your retirement goals. Before you take a withdrawal from your retirement plan, consider the stakes and know the pros and cons of early retirement plan withdrawals. For instance:
  • If you borrow money from your 401(k), you'll owe interest as you pay it back
  • If you withdraw from your IRA or 401(k) before age 59½, you'll trigger an additional 10% tax on top of any regular income tax you'd have to pay on the withdrawal
  • Other rules may apply, so be sure to check with your plan's administrator

4. Help protect yourself with insurance

To avoid having your financial well-being overturned by unexpected events, it makes sense to have adequate policies to cover you and your loved ones. Key types of insurance to consider include:
  • Disability insurance — An illness or injury that prevents you from working for even a few months could wreak havoc on your finances. That's where disability insurance comes in. Disability insurance policies typically replace only part of your income (usually 60%). So you might also want to consider supplemental disability insurance, which could help cover the gap.
  • Home insurance — Homeowners are usually required to have insurance by the bank that holds the mortgage. Renters should have coverage, too, for their own personal belongings in case of fire or theft. Also make sure you're covered for personal liability if someone is injured in your home.
  • Life insurance — When figuring out how much you need, think about how much your beneficiaries would need in order to replace your income and for how long they might need it. Include things like caring for an older family member or college tuition for your kids in your planning. Though all families' needs are different, a general rule of thumb is to have life insurance equal to 7 to 10 years of income.
  • Health insurance — If health insurance is available through your workplace, consider signing up for it since it can be helpful in covering expenses if you were to have a serious medical emergency.
Developing these contingency plans can help you feel more prepared for the unexpected.
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