Figure 3. Obviously the numbers are alarming. But perhaps even more worrying is the volatility. When it comes to jobs, the tsunami hits suddenly, and without much warning. Underemployment Rate from to Source: U.
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Department of Labor. Unemployed, to Source: U. Such volatility has not been seen since the Great Depression. Meanwhile, the unemployed are also spending a longer time out of work, on average, than before. As Figure 3. What does this mean for your finances? You need to know where you can get access to the cash that you need to live at short notice. According to the U. But if a typical family sets this kind of money aside in a bank account as an emergency fund, that would probably constitute most—or all—of their savings. And bank accounts, especially those you can access quickly, are very poor long-term homes for money.
Furthermore, the interest is taxed as ordinary income. Far from it. Instead of beating inflation by maybe 4 percent a year or even more, it is going to be hard-pressed just to keep up. To suggest that families keep most, or all, of their savings in this form in case of emergencies is to condemn them to a poor retirement. There are alternatives. Focus on emergency lifelines, rather just emergency funds. It is almost certainly a needless waste to keep all of your emergency money in a bank account.
But you may not need to, either. You simply have to know how you can reliably get access to sources of money, even in a financial crisis, should you need to. No solution is perfect. It is a question of balancing risks.
In addition to holding money in the bank, here are five other options to consider. Each one has its own risks. Conservative stocks and bonds. Home equity line of credit.
The Basics 39 3. Margin debt. Your individual retirement account IRA. Card debt. You can keep some of it in longer-term investments. Unlike cash accounts, stocks and bonds do fluctuate in value. And they may give you much higher returns with only a bit more risk. In the case of stocks, stable, blue-chip companies with high dividend yields can be a good home for some emergency funds.
Their returns over time are likely to be better than a bank account. And stock dividends are lightly taxed. Their shares are less likely to suffer badly in a slump. Banks, and other highly cyclical stocks, are best avoided in this area.
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In the case of bonds, the most suitable are municipals, high-grade corporate bonds, and Treasury bonds issued by the federal government. It makes sense to stick to short- or medium-term bonds, too. Very long-term bonds, including those issued by the government, can be more volatile in price. The problem with Treasury and corporate bonds is that their interest payments count as taxable income, just like those in a bank account.
And if you hold them in a tax shelter, such as an individual retirement account, you may get penalized for early withdrawals. Municipal bonds, on the other hand, may fit the bill. These are bonds issued by states, cities, and towns. The most secure are known as general obligation bonds, or GOs. Such bonds have almost never defaulted.
The interest payments on municipals are exempt from federal income taxes and those in the issuing state. That makes them a good home for emergency funds. These small differences can make a big difference over time. In the 15 years through December , taxpayers who kept their money in tax-free medium-term municipal bonds would typically have ended up with about 25 percent more than someone who kept it all in taxable one-month certificates of deposit CDs. Munis are not as perfectly stable as a bank account. Their price varies.
There was a period during the crash when they took a hit, too. And it recovered in a few weeks. Munis, of course, make sense only if they are offering a higher yield than the one you would earn, net of tax, in a bank or other high-grade bonds. Home Equity Line of Credit If you have excellent credit and a lot of equity in your home, a home equity line of credit HELOC can be a useful financial lifeline in a pinch.
The interest rate should be very low, because the loan is secured against the value of your home. During the credit crunch banks reeled many of these lines in—just when the customers needed them. What if your financial situation does not recover quickly? What if it gets worse? You can lose your home if you end up defaulting on a loan secured against it.
Margin Debt You may also be able to borrow money from your broker, using your investments as collateral. Margin debt is typically The Basics 41 more expensive than a home equity line of credit. And it comes with another complication. Many of your investments are likely to fall sharply in price during a financial crisis. And your broker may demand repayment quickly. Brokers, unlike mortgage bankers, will watch the market value of your assets constantly.
If your shares or other investments fall too far, the broker may demand more money, or may force you to sell some of them to shore up the account. There are also limits to the amount you can borrow against investments. Margin debt is really only appropriate as a backstop. Your Individual Retirement Account Ordinarily I am not a fan of taking money out of your retirement accounts. That money is sheltered from creditors, as well as from taxes, as long as it is in there. And in most cases early withdrawals run the risk of substantial penalties. But you should at least know your options.
One that may be important in certain emergencies is called a substantially equal periodic payment SEPP. You can withdraw a certain amount per year from your IRA without paying penalties. There are complex technical ways of calculating how much you can withdraw. The payments will be based on your life expectancy and annuity tables. They need to be about the same each year and continue for at least five years. You will need to talk to your IRA provider to organize it and make sure it complies with the rules.
You can also make penalty-free withdrawals before that in certain circumstances. Credit Card Debt This is going to be controversial, and it needs to be clear that this should be a last resort when other options have been exhausted. If you are in a deep short-term crisis, you may be able to borrow money on your cards, or spend money on them and carry a balance. Obviously this is not recommended in most circumstances. As I mentioned earlier, the interest rates are generally usurious. Credit card debt is bad for your wealth. Credit card debt is unsecured lending. Even if you file for bankruptcy, the card lenders will probably be unable to touch your retirement accounts.
As we will see in Chapter 7, if you take the right steps to protect your home they may not be able to touch that, either. This might be called a last resort lifeline. Check Your Big Risks After every flood, homeowners tend to rush out and buy flood insurance.
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