Rainy day fund vs. emergency savings

Posted at 12:21 PM, Oct 10, 2017

Stockpiling savings for stormy days—literal or figurative—can help you cover financial mishaps. When Hurricane Irma hit the South Carolina shores in mid-September, financial planner Laura Scharr-Bykowsky, who lives inland in Columbia, lost three cypress trees in her yard. While she avoided the major damage many people experienced, the money she had tucked away for home maintenance allowed her to pay for the $250 in repairs without much sacrifice. That’s relatively rare in America: A recent Federal Reserve Board report found 44 percent of adults had to sell something or borrow money to pay for an emergency costing $400. For many, a few hundred dollars is enough to tip the scale into debt. So a savings fund is crucial for when emergencies strike. It’s important, however, to distinguish between expected and unexpected expenses. Think of it as two approaches: saving for a rainy day or for a large, unanticipated emergency.

Rainy Day Vs. Emergency Funds

Emergency funds, which ideally provide a three- to six-month cushion of living expenses, are reserved for events that can seriously upend your financial life and are harder to anticipate. Divorce, job loss or unexpected medical expenses would fall into that category. James Kinney, a financial planner in Bridgewater, New Jersey, recommends covering smaller financial hiccups with a rainy day fund. These include occasional expenses you can anticipate, such as car repairs, routine medical expenses and home maintenance. “In reality, most of these small emergencies are to some extent predictable,” Kinney says. “I know there’s a good chance I’m going to need a car repair. In fact, I could be absolutely certain I’m going to need a car repair, I just don’t know when.”

Savings Strategies

You can start a separate bank account to build up an emergency fund to cover unexpected expenses. Quick access to that money is crucial. Creating a rainy day savings strategy starts with getting a handle on any future expenses. For most people, monthly expenses such as house payments, utilities, insurance and groceries stay steady. Other costs are less frequent but not technically emergencies. Make a list of the expenses you’ll probably have to pay in coming years. In addition to car maintenance or house repairs, this could include kids’ braces or veterinary bills. Kinney and Scharr-Bykowsky recommend setting up multiple savings accounts, one for each category. You can use a regular savings account or a money market account—both allow ready access to your cash if you need it, but a money market account may include the ability to write checks. Find a bank that offers multiple savings accounts with no monthly fees. Certificates of deposits and investment accounts aren’t ideal for storing rainy day or emergency savings. Withdrawing money on short notice can result in penalties or even financial loss. Get in the habit of socking away part of your monthly income into each of your savings funds. You can start small with just a few dollars a month. If you have direct deposit, Scharr-Bykowsky recommends automating your savings by funneling a portion of your paycheck into the savings buckets. “For maximum peace of mind, you want to have enough in each bucket to cover the largest expense we can reasonably expect in that category,” Kinney says. Scharr-Bykowsky says creating funds with specific intent can help people save. “When our goals are more visual, we tend to save more,” she says. “Name that account. Make it visual.”

Avoid The "Savings Blob"

Many people throw extra money into a single savings account and pull from it whenever their checking account balance runs low, Kinney says. Scharr-Bykowsky calls this the “savings blob.” “It doesn’t really have a purpose,” she says. “You just dip into it whenever. You don’t think, that’s for when you lose your job or, ‘Wait, that’s our vacation.’” When real emergencies strike, your general savings account may prove insufficient. You might then turn to expensive ways of borrowing money, such as credit cards or home equity lines of credit. Separating savings into buckets of rainy day funds and an emergency fund has an additional benefit: You’ll be far less likely to tap those reserves for purposes other than what they’re meant for. That’s due to a phenomenon in behavioral economics called mental accounting, Scharr-Bykowsky says. People tend to stop spending on one category when they know the money in that bucket is gone, even if other funds are available. Making clear savings categories for future expenses means you’ll hesitate before using the medical expense fund on a new phone. Though you’ll never be totally prepared for everything life throws at you, knowing you’ll be able to ride through some of the financial bumps in the road should help you rest easier. “Savings,” Kinney says, “is never wasted.”

The article Rainy Day Fund Is as Crucial as Emergency Savings originally appeared on NerdWallet.

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