How to Save for a Rainy Day

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If you suffered a crisis like a serious illness, job loss or investment setback, would you be financially prepared to handle it?

Most people know they should have a rainy-day fund, enough money to cover expenses for three, six or 12 months. But most don’t actually have a fund earmarked for just that purpose. Instead, the rainy-day fund is mingled with other cash or investments.

Of course, even a healthy fund might be too small if things were really bad.

As the smoke cleared from the financial crisis, some economists said big Wall Street firms should be required to have a kind of “living will” that would lay out in advance the steps to dismantle the company and sell its parts in the most orderly way possible. The idea was to avoid lurching from one response to another, sometimes at cross purposes.

But what would such planning entail for a typical household?

Generally, it would be a series of actions to take as the emergency got worse or lasted longer, so the family could prepare for the next step well before it had to be taken. Ideally, the process would enable you to weather a crisis longer and postpone desperation moves like walking away from your mortgage or taking an unsuitable job – things that could do permanent damage.

The first step, obviously, is to build that rainy-day fund, socking money away in checking or money market accounts that are safe and also accessible, even if interest earnings are small.

Another key step is tightening the budget, though often this is hard to do. Many who enter a crisis are in a state of denial for some time, hoping things will improve or assuming they must keep up appearances. You’ll have a better chance of surviving a crisis if you trim your budget instead. So start canceling vacation plans, cut out entertainment and meals out, drink tap water instead of bottled, get rid of cable tiers, fancy phone plans, and so forth. There’s a lot of money tied up in these things, and you might need it sometime soon.

Think of the things you might sell, like the second car, boat or other toys. Even if these items sell at a loss, they’ll provide some cash. And the sales can reduce ongoing expenses like insurance and mooring costs.

Next, set up a sequence for tapping long-term investments in an orderly way. You’d want to keep the investments with the best prospects, if possible, so you’d plan to start by selling the ones that aren’t likely to do as well.

In sorting through these, you might also consider taxes. If a crisis like a job loss strikes late in the year, you could boost your tax bill by selling profitable investments. Look for some that don’t yet have big capital gains, or are in a down cycle. This isn’t as big an issue if you lose a job early in the year and will have little income to report.

Generally, it’s best to avoid drawing cash out of IRAs and 401(k)s because of the 10% penalty on withdrawals before age 59 ½, so these accounts should come late in the liquidation process.

It might also pay to set up a home equity line of credit, so you can borrow at a low interest rate rather than max out your credit cards. And you might look into borrowing from your 401(k), assuming the crisis does not involve losing your job. Generally, these loans must be paid back when you leave.

Finally, set priorities for paying the bills. Food, electricity, water and heat are necessities that should come before things like debt payments, even though missed payments will torpedo your credit score.

If you have student loans, contact the lender, as many federal loans have forbearance features that will allow you to postpone payments in a crisis. You should probably keep up with your car payments so the car isn’t repossessed. If you fall behind in credit card payments, the cards will be cancelled, but the card company won’t repossess the things you bought with card.

Although defaulting on your mortgage will destroy your ability to borrow for years, it could well take the lender more than a year to foreclose and remove you from the home. In a crisis, it probably makes more sense to keep up with a car payment than a mortgage, though you might consider selling the car to buy something cheaper.

The key is make decisions while you still have choices.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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