Wednesday, September 3, 2008

Be your own financial planner part 1 - Be prepared for emergencies

You will have financial emergencies in your life - your car will need work or your furnace will break down.  You will also experience other hardships that have a major financial component - you will experience the loss of a loved one or you might lose your job.

There is nothing that you can do to prevent things like these from happening to you.  However, there is a great deal that you can do to ensure that you are financially prepared for them when they do happen.

There are two main elements to financial preparation for emergencies: life insurance and cash reserves.  These are the first components of your financial life that you should address.  Until you are prepared to deal with financial emergencies that could happen tomorrow, there is no point in saving for financial goals that are still years away.

Imagine that you work out a stellar financial plan that will enable you to fund your retirement and all of your other financial goals but neglect to set aside emergency cash reserves or purchase life insurance.  If your car breaks down the next day and you need to pull money from a retirement account or take on debt to have it repaired, or worse yet, if you or your spouse is run over by a bus, all of your planning won't have helped you.

Therefore, I believe that the first step in any financial plan is to purchase the proper amount of life insurance for you and your spouse.  You should include enough insurance to replace lost income, cover childcare expenses, and take care of any other financial hardships that would be brought about by you or your spouse's death.  Term insurance is generally the cheapest, and often the best type of insurance for these needs.  This earlier post has more information on determining your needs for insurance and this one discusses the different types of insurance available.

Once you have your life insurance squared away, you need to make sure that you have an emergency cash reserve set aside in a savings account.  This money should be set aside only for emergencies and should be in a separate account so that you are not tempted to spend it or use it for anything else.  Many professionals recommend that you keep 3 - 6 months worth of living expenses on hand.  Personally, I keep a bit less than 3 - 6 months of living expenses.  I like to have my money invested and working for me as hard as possible.  Because I work for the government I consider it very unlikely that I will lose my job on short notice.  I also have access to credit and investments should I need to raise a large amount of cash quickly.

The proper amount of cash reserves is something that you and your spouse will need to decide together.  I would advise you to set aside at least $1,000.  However, decide an amount that makes you and your family comfortable.  Frugal Dad has a great post about his thoughts on the proper amount for an emergency fund.

Once you have met your life insurance needs and set aside cash for emergencies, you are less susceptible to the financial ups and downs of life and are ready to tackle the rest of your financial goals.

Step one in your financial plan is to obtain adequate life insurance.

Step two in your financial plan is to set aside an emergency cash reserve.

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