The Key to Finding Financial Peace of Mind

Financial stability is one of life's biggest concerns, but one that proper planning and follow-through can minimize significantly. The key to finding financial peace of mind is in creating a "reserve" fund for unexpected emergencies. It's a simple idea, but one that too many people overlook, until it's unfortunately too late.

Most people expect insurance policies to cover expenses in the case of an unforeseen event. Today, you can purchase insurance to cover just about anything, from automobiles, homes and boats, to disability, life and long term care. You can also get an umbrella liability policy that protects you from being sued for just about any reason. You can even buy insurance to pay your credit card bills in case you lose your job. While the actual likelihood of these events is debated endlessly by statistical experts and economists, what is certain is that almost none of these policies will cover the full cost of an unexpected event. Instead, they all include provisions for deductibles, waiting periods, out of pocket expenses and key exclusions.

A simple medical condition or accident can wreak havoc on a family. Take the following example:

Brenda is a retail store manager. She is married with two children and makes $60,000 a year. Lately, Brenda has been having mysterious abdominal pain. She goes to see her doctor and is diagnosed with a medical condition that requires unexpected surgery and 50 days of recovery before she can return to work. The procedure costs $5,000, including all doctor and hospital bills, but luckily, Brenda has health insurance. In another stroke of luck, Brenda also had opted for disability coverage through her employer that replaces 50 percent of her income should she be unable to work. All seems well, but Brenda's family is in turmoil. Her medical coverage has a $1,000 deductible and she is required to pay 10 percent of her medical bills up to the out of pocket maximum of $5,000. This means Brenda responsible for $6,000 of her medical expenses. If this wasn't enough stress, Brenda's disability policy has a 60 day waiting period. She had only had accrued 5 days-worth of sick leave this year and she will not receive any income replacement payments for the 1.5 months she has been out of work. This unexpected illness has caused Brenda to lose $7,500 in income, with the total out of pocket cost to Brenda's family of $13,500. This is more than two and half months of Brenda's salary.

While lower insurance deductibles and shorter disability waiting periods are available, they don't come cheaply. In fact, most people end up paying for insurance they never use, meaning that insurance companies are maximizing profits on significant numbers of unexercised policies. All that to say, it's important to strike a balance between insurance costs and personal savings. Building an emergency fund is essentially personal insurance -- it's there for emergencies if you need it, or it can grow as an interest-accruing investment if you don't.

Of course, there are other ways to pay for emergencies. Home equity loans are one option, borrowing from a family member is another. Hospitals take credit cards. You could even draw down your retirement savings. However, most of these options would only serve to amplify the emotional and financial stress of an unforeseen event. Credit card interest is usually higher than any other type of interest. Hospital bills are bad enough without adding a 15-20 percent interest premium. Securing a home equity loan or borrowing from family requires time and attention away from healing, often through situations that are disruptive, exhausting or even embarrassing. And then you're still faced with the ongoing stress of loan payments as a continued reminder of an illness or injury. Drawing down retirement accounts means you are liable for taxes and penalties associated with early withdrawals. Plus, the long term effect of reducing retirement savings means reduced retirement income and possibly a much different retirement scenario than had been originally planned.

So what's the right approach?

There needs to be a clear distinction between savings and an emergency fund. While savings can be used for a vacation or special purchase, an emergency fund needs to be strictly maintained for emergencies, with clearly stated guidelines regarding what constitutes a family emergency. Acceptable emergencies might include income replacement in the case of an illness, injury, or job layoff, non-insurance covered medical expenses, and deductible payments on auto and homeowner's policies.

While your teenage daughter's new car or a surprise family beach vacation sound like fun, but they are probably not emergencies. Each time the emergency fund is reduced or depleted, the risk of financial turmoil from an unforeseen event is amplified. Use of emergency funds should only be for your family's stated emergency purposes. And once funds are used, replenishing the fund should be a top priority.

How much you should save in an emergency fund depends on your income and potential risk factors. One rule of thumb is to save six months of income based on the highest income earner in a family. This amount might be too much for some and too little for others. If you have very low deductibles for disability and health insurance, and you're employed in a high-demand industry, then a lesser amount might be appropriate. A valuable exercise is to simulate potential emergency situations and see what it would take to keep your life in balance.

Emergency funds are best kept in low risk savings or investment accounts. While it's understandable to seek a reasonable rate of return on your savings, it's more important that the money is available when you need it. Loss of capital, or the inability to access funds, undermines the point of having an emergency fund at all.

Taking the time now to save for the unexpected can mean securing your future financial stability -- and providing important peace of mind without handing over a fortune to the insurance industry.