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Morningstar.com's Interactive Classroom Course 104 Building Your Emergency FundIntroduction You've figured out your goals. You know what they'll cost. So you've put all of your money into your investment portfolio. Then you lose your job. Where will you get money for food, rent, your bar tab? You don't want to dip into that investment portfolio. After all, you've built it with a particular goal and time frame in mind. Touch it now and risk making your future dreams unattainable. That's why it's important to set aside money in an emergency fund before you begin investing. Here are some pointers for what your emergency fund should cover, how long it should last, and where to put it. What to IncludeDon't assume that any future unemployment insurance payments can take the place of an emergency fund. Think of collecting unemployment as a way to strengthen the safety net you're constructing. It shouldn't be your sole support. And if you do collect unemployment, your emergency fund simply will last longer. We recommend that you cover all conceivable expenses in your emergency fund. Food and Shelter Unless you're ready to move into your brother-in-law's basement, be sure to cover your rent or mortgage payments, too. And don't forget utilities--gas, electric, water, phone, and even cable and Internet. Transportation Insurance and Health Insurance premiums are often the first things to go when money gets tight. They shouldn't be. One of the quickest roads to penury is to let your health insurance lapse and to find yourself with a serious health condition. Set aside money for routine dental and eye care, for prescriptions, and for any other health expenses your insurance doesn't cover. Once again, if you have pets, put their vet bills on the tab. Taxes Finding a New Job That's a long list to compile and come up with hard numbers for. The good news is that you don't have to try to brainstorm every conceivable expense. Instead, track what you spend in the next few months and use that as your baseline. Then add in any other possible expenses, such as taxes or finding a job, that didn't pop up during those months. If you spent money on movies or your health-club membership, include that. If you're out of work, taking in an occasional flick and working out may help relieve some of your stress. How Long Should It LastMost financial planners recommend setting aside six months' worth of living expenses in an emergency fund. What if your "emergency" ends up lasting longer than six months? If you take the liberal view of living expenses that we've been taking so far, your emergency kitty likely will last a little longer. Further, we haven't included payments from unemployment insurance. If you do collect unemployment, your emergency fund should last longer, too. Of course, you may not be able to pull all of your emergency-fund money together at once. Treat it as a goal. Maybe you can cover one or two months' expenses now. Add to that kitty over time. If you get a tax refund, put it in your emergency fund. A bonus at work? Sock at least part of that away. But in general, don't invest elsewhere until you have a full emergency fund. (The exception to this may be your 401(k) plan. If your employer offers matching funds, you should strongly consider contributing at least enough to maximize your company's match. Otherwise, you are leaving money on the table with every paycheck.) Where to Put the Emergency FundKeep your emergency fund separate from your regular bank account. That way, you may feel less of an urge to tap into it in normal times. But thanks to automatic teller machines and online transfers, you'll have easy access to the money if you do need it. A money-market fund is a great place for your emergency dollars. Money-market mutual funds invest in super-short-term, high-quality debt and are among the most conservative funds available. Their prices (or net asset values) don't move around much. In fact, because they invest in bonds issued by extremely stable debtors, such as the U.S. government and large, financially sound companies, money-market funds can maintain a steady $1 net asset value, making them ideal for investors who don't want to risk their principal. Money-market funds also offer several features designed to help investors manage their cash reserves. Most offer limited check-writing privileges. It doesn't take much to start out, either. Many money-market funds have low minimum investment requirements. Why not just stick with a bank? Money-market funds often pay as much as a percentage point more than banks' money-market accounts do. You'd get even less interest than that if you stashed your cash away in a checking or savings account. There's a minor catch: Unlike consumer bank accounts, money-market funds are not FDIC insured. That means that the government won't step in if something goes haywire and your money-market fund loses money. However, that danger is minimal. Money-market funds are regulated by the Securities and Exchange Commission, which enforces strict limits on the types of investments that these funds can make. Thus, it is unusual for a money-market fund to "break the buck," or fall below its $1 net asset value. Unusual--but not unheard of. For instance, during the credit crisis of 2007, reports indicated that some money market managers were holding stakes in problematic securities, including so-called SIVs (structured investment vehicles), which have taken a hit amid the market turmoil. But even in cases such as these, the funds' parent companies typically steps in to support the funds, and no investors lose money. Investors can take the safer route by choosing a money-market fund that invests exclusively in the direct obligations of the U.S. government. The drawback is that these funds typically pay out less income than those investing in corporate debt, too. Choosing a money-market fund doesn't have to be hard.
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Quiz 104 |
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1 | An emergency fund should include? | ||
a. | Enough money to cover expenses for at least six months. | ||
b. | Enough money to cover the expenses that unemployment insurance won't cover for at least six months. | ||
c. | Enough money to cover expenses for three months. | ||
2 | How can an emergency fund protect you from additional taxes? | ||
a. | You don't have to pay income taxes when you're unemployed. | ||
b. | You don't have to pay property taxes when you're unemployed. | ||
c. | You won't have to sell investments from your portfolio and pay taxes on the proceeds. | ||
3 | Which statement is true? | ||
a. | Invest before you build an emergency fund. | ||
b. | Invest after you build an emergency fund. | ||
c. | Invest while you're building an emergency fund. | ||
4 | Where shouldn't you put your emergency fund? | ||
a. | In your regular savings or checking account | ||
b. | In a separate bank account | ||
c. | In a separate money-market fund | ||
5 | Which statement is false? | ||
a. | Money-market funds generally invest in super-short-term, high-quality debt. | ||
b. | The net asset values of money-market funds stay around $1. | ||
c. | Money-market funds are FDIC insured. |
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