Losing His Job Taught This Former Bank Exec One Big Lesson
Although personal finance experts may debate the required size of an emergency fund, almost all agree that you should have one. Anywhere from $1,000 to eight months of living expenses seems to be the general guidance. And it doesn't take a rocket scientist to figure out why an emergency fund is needed. Unexpected things can happen. And even though your income may disappear, your expenses do not. In fact, they often get larger during emergencies (for example, with large medical bills).
Borrowing money during an emergency can be incredibly expensive. Short-term borrowing options include:
- Credit cards, if you have available credit. Interest rates on credit cards average 15 percent or higher. And if you miss a payment, expect to see that rate increase to well over 20 percent.
- Borrowing against your overdraft limit on your checking account. But typically the limit is low ($500 or less), and the fees are extremely high (an average of $35 per transaction).
- Payday loans, which are just as bad as overdrafts, or even worse. You would end up paying $20 for every $100 you borrow for 14 days.
- Title loans, which are just as bad as payday loans -- except they take your car if you don't pay them back.
- Borrowing against your 401(k), which harms your retirement planning and has punitive tax implications.
- Using your home equity line of credit. The good news is that the interest rate is low. The bad news: You lose equity and could end up paying the debt back for decades.
If Only I'd Taken My Own Advice
In 2008, I made a career change. I left my job as chief risk officer of Citibank's (C) consumer franchise in Russia and moved to take a new job in New York. While in Russia, I had saved enough money for a down payment and decided to buy a house. So, within a few months I quit my job (as did my wife), switched countries and bought a house.
My plan allowed me to put a 20 percent down payment on my home, complete necessary repairs and maintain a six-month emergency fund. Unfortunately, life did not go according to plan.
First, the house started to cost more than I'd planned. Although this surprised me, all of my homeowner friends just laughed at my naiveté. Everywhere we looked, the house needed more work. It culminated with a loud explosion in the basement, when our boiler broke.
Unfortunately, I continued full speed ahead with my home repairs. Although fixing the boiler before winter certainly counts as an emergency, I should have delayed other work. The guest room did not need a new floor and the front lawn did not need a new brick path. But I continued to write checks every week, as my bank account balance raced towards zero.
I Delayed Replenishing My Emergency Savings
Given that I had just started a new job, I couldn't imagine being out of work any time soon. I did the calculations and decided to fix up the house and then just save money over the next 12 months to replenish. I really wanted our house to feel like a home.
Then the 2008 economic crisis hit, and I lost my job. I was facing the prospect of no income, no emergency savings and a large mortgage payment. I felt foolish. Emergencies are never planned, and it is possible for more than one bad thing to happen at once. To add insult to injury, the price of homes in my neighborhood plummeted. If I'd sold my home in a rush, I would have lost my entire down payment, not to mention the money that I had spent refurbishing the house. In a matter of six months, I could see eight years of hard work and planning go up in smoke.
The worst part of having no money in the bank is the stress. You feel trapped, foolish and afraid. I had always prided myself on having a good job, money in the bank and a good financial plan. All of a sudden I dealt with the consequences of my actions. And the consequences were entirely avoidable. I could have easily had six months of living expenses -- had I waited to pay for the home repairs.
What I Did
The good news was that I got a few months of severance. I set two objectives:
- I did not want to sell my home. I felt that, over time, home prices would come back, and I did not want to lose 100 percent of my down payment.
- I needed to get a job as quickly as possible
In the end, I was fortunate. I quickly found a new job, and paid off the credit cards before I owed a dollar of interest. And I learned my lesson. I never wanted to feel that stress again. My definition of emergency has been narrowed considerably.
Here are some of the things that I learned:
- Create a completely separate emergency fund. I recommend putting it in a different bank, where you get the highest interest rate. And lock it up in a one-year CD. Ally Bank, for example, pays 1 percent on a 12-month CD. The interest rate will be much better than your traditional bank (which pays close to 0 percent). But, psychologically, you are locking it up to remove any possible temptation and use it only in a true emergency.
- When an emergency strikes, be honest with yourself. Is this a short-term or a long-term emergency? In a short-term emergency, you have a temporary issue and will be able to return to your old life. Create an emergency budget, which includes drastic budget-cutting and a target date to replenish your emergency fund.
- React quickly. If it is a long-term emergency, with a permanent loss of income, than you will need to cut your fixed costs, and quickly. If that means downsizing your home or selling your car, you need to do it quickly. The longer you wait, the higher the chance that you will just end up borrowing for an unsustainable life.
- If you do end up with some debt, make sure you don't pay high interest rates. There are plenty of 0 percent offers out there, like the one I used. I keep a list of the best 0 percent offers at MagnifyMoney, my website.
Nick Clements is the co-founder of MagnifyMoney.com, a website that makes it easy to compare and save money on banking products. He spent nearly 15 years in consumer banking and most recently he ran the largest credit card business in the United Kingdom.