Emergency reserves serve a single purpose: if all other sources of income and investments fail, we can still survive for a few months and use that time to get back on our feet. In this article we'll explore ways to create emergency reserves.

How Much?

To be useful, the emergency reserve should have enough cash to cover at least three months of our family's expenses — we shouldn't underestimate the time required to get back on our feet. If we can afford it, a larger emergency reserve is somewhat better; however, too big a reserve may also cause us to miss opportunities for investing some of that money into income-generating investments.

Emergency Reserve Options

An emergency reserve can be created in several ways, depending on what investments we have (or not).

Cash

The simplest way to create a reserve is as cash, in a bank account. This has the advantage that it is immediately accessible. It might be tempting to invest this money to make it grow, but since the emergency reserve is our last resort source of income for short-term survival, it is best to maintain it in the simplest form, i.e., as cash.

Line of Credit

If we do have other investments, then a line of credit from a bank can also serve as a source of emergency fund, should we need it. But, keep in mind that a line of credit has usually a much higher interest rate than a conventional loan.

Home Equity Loan

If we happen to own a home with a significant portion of the home mortgage loan paid off, we can also think of our equity in the home as a potential emergency reserve source, with a home equity loan being the means to accessing that money. Though people typically use home equity loans to renovate and enhance their homes, the lender itself does not place any restrictions on how the money can be used. Thus, a home equity loan can very well be considered as a potential emergency reserve.

Life Insurance

Yet another potential emergency reserve could be our life insurance or annuity, if we have one. Several life insurance schemes allow us to take a loan from the available funds. But, there is a price to pay here. Taking a loan from the life insurance or annuity usually diminishes the insurance's total value and thus could result in a lower death benefit value.

Other Uses of Emergency Reserve

There are instances where dipping into an emergency fund makes sense even we do have other investments. Before doing so, we need to think through the pros and cons of this very carefully. Things to consider:

• Is it difficult or time-consuming to get the money from other investments, especially if the money is needed urgently?
• Is it expensive to get the money from other investments? I.e., will withdrawing from an investment greatly reduce the interest/gain that the investment is generating?
• Once the expense event is over, can the emergency reserve be replenished fairly quickly?

Each person's situation is different, so the above are just general rules of thumb. But in all cases, the emergency reserve is not to fund our next vacation or shopping spree!

Summary

We saw that an emergency reserve provides us and our family peace of mind in the event of drastic reduction in our financial status beyond our control. It gives us some breathing space to recover from the losses and to create financial alternatives.

We also saw that, depending on our financial status − the number of investments we have, etc., we have several options in creating our emergency reserve.

A qualified financial advisor familiar with your financial status should be able to help you create an emergency reserve that is best suited for your lifestyle and needs.