Bridging The Gaap

What is overdraft?

Overdraft is when your bank account has a negative balance.

What causes someone to go into overdraft?

To put it simply, people go into overdraft on their accounts if there is not enough money in the account to cover a certain request for money. Many things can cause someone’s account to go into overdraft, but the basic problem is that there isn’t enough money there to cover a request, causing you bank balance to run into the negative.

Some of the major reasons people may go into overdraft include:

1. Poor money management skills: Purchasing things when you don’t have enough money to buy them is not only dangerous to your financial well being, it’s also an excellent way to put yourself into overdraft, incurring hefty fees.
2. Automatic withdrawals: If you have authorized automatic withdrawals form your bank account, you need to make sure you have enough money in the account to cover the withdrawal. If you don’t, most of the time the transaction will not go through because there is not enough money to do so, and you can be charged a hefty fee. This happened to me once, as I forgot about an automatic withdrawal from my account into an ING sub-account for my christmas budget, and the overdraft fee was $40, which I was able to get reversed.
3. Bank or account fees: For those who do not have low-fee or no fee bank accounts, monthly or annual automatic fee withdrawals from your account can cause you to go into overdraft. The bank will take its fee when it is due, and if there isn’t enough money in the account to cover it, you will be sent into overdraft and will have to pay a fee. One should always have a “float” of $50-$100 in their accounts at all times to make sure their bank fees will never cause them to go into overdraft.
4. Bank or Merchant error: It rarely happens, but sometimes a purchase or charge that was $5 can accidentally be charged as $50. It doesn’t happen a lot, but sometimes banks and merchants make mistakes, which can cause you to go into overdraft. If this is the case however, the charges can usually be reversed, but always remember to keep those receipts and bank and credit card statements!

How much will I be charged if I go into overdraft?

Overdraft fees can range from a few dollars to upwards of $40 or $50 dollars. These fees are incurred every time your account balance dips below zero.  Also, some banks may charge you a hefty fee PER DAY that you are overdrawn (source). This cost can sometime be offset by purchasing overdraft protection, though that`s not the solution for everybody (more below). 

The important thing to remember is that it doesn’t matter by how much you are over drawn: simply being a few cents below a zero account balance is enough for them to charge you a large fee: this woman was charged 28 pounds ($56 CAD) for going 37p ($0.74 CAD) into overdraft (source, 2nd testimonial).

What can I do if I’ve been charged overdraft fees?

If you have incurred an overdraft fee, it never hurts to call the bank to see if you can negotiate a reduction or even a reversal of the fee. I was able to have my $40 overdraft fee reversed, but this was partly due to the fact that I hadn’t had any overdraft problems for at least 90 days and I believe due to the fact that I politely implying that I would be willing to take my business elsewhere.

Not every customer is a customer worth keeping however, and overdraft fees are big business for banks, especially in rough times such as we’re seeing with the Credit Crisis. (source) 

While there is some question as to the legality of overdraft fees, for now it is important to be aware of them, and to be aware that there is a high price to pay for dipping into overdraft, by accident or by design.

How can I protect myself from going into overdraft?

There are two ways:

1. Practice good money management skills: never spend more than you can afford, and always try to have some 50 or 100 dollars (or more as need be) extra in your account as a float in case you forget about bank fees that are coming due, or that automatic withdrawal you have into your emergency fund at the beginning of every month.
2. Most banks will allow you to purchase overdraft protection, which can be useful for some people, especially if you have to deal with many deposits and withdrawals that are difficult to time. Overdraft protection can be purchased for a monthly fee in addition to your current account fees, for which you will receive a certain amount of leeway should you run into overdraft. Some banks waive the fee for months where you do not use the overdraft protection. 

Overdraft protection is very similar to a line of credit, however, because in most cases you can write checks for the amount of overdraft protection your have, and you will pay interest on any amount within your overdraft protection that you do use.

Let’s look at an example: if you have $5000 worth of overdraft protection, it works in much the same way as a line of credit from a bank. You could write one or many cheques if you needed too for any amount, so long as it doesn’t exceed that $5000. Any amount that you do use will be subject to interest charges.

If you have overdraft protection and you manage to exceed even that (ex: you have $5000 worth of overdraft protection but you are $6000 into overdraft, you will pay overdraft fees as soon as you pass the limit of your overdraft protection (so in our example, you’d be hit with a hefty fee at $5000.01 and over).

What has your experience been with overdraft and overdraft charges? Leave a comment and let us know!

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What Is The Credit Crisis Part 4: The CRISIS

Why do businesses need credit?

Many businesses need credit for their day to day business operations. Some companies simply don’t have the cash to pay their suppliers, and do so with credit, while others simply prefer to do so for various reasons.

Remember how I said lots of institutional investors bought and held CDOs in their portfolios? Some big businesses ended up owning CDOs as well, and also saw their worth vanish with the default of the mortgages backing the securities (is this all greek to you? You probably haven’t read part 2 of this series!). With the decrease in the value of their assets, the companies had less that they could sell off or leverage during a crisis, and so became more likely to rely on credit.

Unfortunately, due to the credit crunch this credit became more difficult and more expensive to obtain (see why in part 3!).

Why is it a problem if big/small businesses can’t access credit?

During a credit crunch, it becomes far more difficult for companies, big or small, to get the credit they need from banks. This credit may be necessary to sustain day-to-day operations, therefore, if a company cannot obtain this credit it risks going out of business.

Let’s take the case of hypothetical automaker, which at this point in time needs credit from a bank to survive. If the automaker cannot access this credit, it risks going out of business. If the automaker starts having trouble, or goes out of business entirely, two things can happen:

1. Employees of the automaker no longer have a job.
2. Suppliers to the company might also risk going out of business.

1) Employees of the automaker no longer have a job: This is a problem because the unemployed no longer draw a salary, and therefore don’t have any money to spend. This means there may be a decrease in the overall level of consumer spending, which can spell trouble for an economy, especially one with recessionary fears.

This is because when consumers don’t have any money to spend on products, producers don’t make any money either: fewer people are buying their products, leading to a decrease in revenue. Firms that produce items that people aren’t buying risk going out of business, which leads to further unemployment: it’s a vicious circle. People need to have jobs to make money, and people need to make money to buy things; but when people lose their jobs, they stop making money, and can no longer afford to buy things, which leads to more producers going out of business, which leads to more job losses. And so it goes.

2) Suppliers to the company might also risk going out of business: we touched on this briefly in the preceding paragraph, but let’s take a more detailed look. Let’s say our automaker goes out of business, what other kinds of businesses might this collapse affect?

What about the company that provides electronics for the cars? If the automaker was a big customer of this firm, the electronic company might see its sales decreased substantially. This can put the firm in a precarious position depending on how big of a customer the automaker was: sometimes it’s a big enough customer such that if the automaker collapses, the electronics company would collapse as well. And that’s just the company that makes the electronics for the automaker’s cars: what about the company that provides the upholstery? What about the company that manufactures the CD players? The wheels? The seats? All of the supplier companies risk going out of business if the automaker collapses. As we touched on before, every firm that collapses creates more unemployment, which means less consumer spending, which in turn creates more unemployment.

So why are my investments being affected?

When a company starts getting into trouble, frequently it share price decreases and if a company gets into enough trouble in share price can drop dramatically. If a company’s shares become rapidly devalued, it’s a little bit like a sinking ship: everyone wants to get off, and no one wants to get on. People start selling their shares in this company, which in turn leads to greater devaluation of the company stock. If this happens, then even more people start selling their shares, which leads to greater devaluation: again it’s a vicious circle.

This is a problem for companies, because share equity (the money they get when they sell shares of their firm to ordinary people) can be an important source of financing. Cut off this source of financing and the company might find itself in trouble. An inability to obtain credit to make up for this loss of share equity only makes things worse. At this point, worthless assets, worthless stock, and an inability to obtain credit, the company becomes almost entirely dependent on the revenue from selling products to keep itself afloat; as we’ve seen, it doesn’t take much to effect a decrease in consumer spending.

Oh Jeez!

Yeah, I know.

So what can we do?

Ordinary people can do two things:

1. They can take a good, hard look at the economic policies of the political parties
2. They can continue to pay taxes

1) Observing economic policy: Ordinary people should take a good look at the credit crisis from a political standpoint as well, especially with the upcoming November 2008 elections (Canadians had their chance on October 14th 2008). You should look at economic policies and histories (such as their view and history of implementing regulation in the financial markets) of both major parties and then decide whether or not this affects your view your chosen candidate (it may, it may not). The economy is, of course, only one thing you should consider when voting, but it is important to realize that, in the words of my father: “Democracy is hard”, meaning you need to take the time to look at all parties, all policies, and your own feelings, which will allow you to make a more informed decision.
2) Continue to pay taxes: at this point, fixing the credit crisis is in the government’s hands as the crisis has simply grown too big, and too complex to be affected by individuals. So-called “bailout” plans, if properly thought out, may have a very positive effect on the current crisis gripping the global economy. But to fund such endeavours, the government needs money, and all the governments money comes, ultimately, from ordinary people like you and me.

What’s important now is that we make sure, through our votes and our tax dollars, that we never repeat the mistakes of the past.

For More Information:

You can check out this excellent video about General Motor’s current woes here and another one here. For more on GM plant closings, click here.

Follow this link for more infor about GM and several other automaker’s rapidly devaluing share price. 

A Note About This Article:

Gosh, it seems so simple in retrospect…but what did YOU think? Was this series helpful? Have I missed something you thought should be included? Are you still unclear about something? Let me know by leaving a comment below!

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What is the Credit Crisis Part 3: The CRUNCH

Why is it a problem for banks to have worthless assets?

The problem is that banks must trade with other banks to help sustain the stability of the economy. Banks, owing to the nature of deposits and withdrawls, can sometimes be short at the end of the day. Banks then often loan to one another overnight (the lender is often repaid the next day) because it is cheaper than borrowing from the Federal Reserve or The Bank of Canada. This represents a huge source of liquidity for banks and the economy as a whole (remember that liquidity just means how easy it is to access money).

When banks started seeing worthless assets on the statements of other banks, they became much more wary about loaning to one another (source).

Why are banks afraid to loan to one another?

Think of it this way: would you loan someone money if you didn’t think they could pay it back?

The banks see it the same way; a bank is not going to want to loan any money to another bank that has heavy losses: it would be like loaning money to someone who has already run themselves deeply into debt, someone who could not afford to repay you. Banks won’t loan other banks any money if they are afraid the borrower will never be able to pay back the loan.

When banks become unwilling to lend to one another they must borrow money from other sources such as the Federal Reserve or The Bank of Canada, which is more expensive and more difficult than borrowing from each other (this is purposeful on the part of the national banking institution, to encourage banks to loan to one another). Now that banks have increased expenses however, they must increase their revenue to compensate, and it’s at this point that the economy experiences a Credit Crunch.

What is a Credit Crunch?

A Credit Crunch is a period of time in which credit becomes more expensive and more difficult to obtain (source). Should one need to seek credit from a financial institution during a credit crunch, one would find that interest rates are higher on the loans (making credit more expensive), and that the qualifications for obtaining a loan are more strenuous (making credit more difficult to obtain, especially for people with below average credit histories).

Why do we enter a credit crunch when banks refuse to loan to one another?
When banks become unwilling to lend to one another they must borrow money from other sources such as the Federal Reserve or The Bank of Canada, which is more expensive than borrowing from each other (this is purposeful on the part of the national banking institution, as it encourages banks to loan to one another). Now that banks have increased expenses, they must increase their revenue to compensate. This mean loans with higher interest rates (ie: loans that are more expensive) and loaning money only to people who are likely to pay it back. 

What are the effects of the credit crunch on ordinary people?

Ordinary consumers will feel the effects of the credit crunch in 3 major ways;

1. Credit becomes more expensive: Because the banks must borrow at more expensive rates, they must also loan at more expensive rates to compensate. This translates to higher interest rates on consumer loans such as mortgages.
2. Credit is more difficult to obtain: Banks will still loan to consumers, just not to EVERY consumer. Just as people can lose faith in banks, banks can lose faith in some of their customers, and this is exactly what happened with the sub-prime section. Banks are no longer able or willing to extend credit to any yahoo who asks for it, not like they could (and did) before with the whole sub-prime mess. Therefore, if you pose an above average risk to the bank (or even an average rick) you may find it difficult to obtain credit, as banks are no longer willing or able to take a chance on you.
3. Oh yeah, there’s the little issue of a tanking economy…but we’ll talk about that in a second…

            

But again, the economy doesn’t care if Joe and Jane Smith aren’t eligible for a big mortgage: the economy cares when businesses, big or small, are unable to get the credit they need to survive.

And that, my friends, is where the CRISIS begins…let’s find out why in Part 4: The CRISIS!

A Note About This Article:

Banks and how they work are particularly fascinating subjects. Should you become interested in understanding how banks operate, consider checking out a good economics textbook at the library. Online sources can be very helpful, but you must beware: there’s a lot of very biased media (usually video) circulating that will claim to offer the “truth” about banking and banking institutions. It’s not the fact that some of the information may be controvercial that sets of warning bells, it’s when the “truth” is being used to push an agenda that bothers me. As a general rule, I tend not to pay too much to anything that a) is very clearly biased and/or b) can’t give any good sources/is not published by a credible source itself. Critical thinking caps on everyone!

This article was included in the 34th Money Hacks Carnival, hosted by Where You Are Now.

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis (Coming Oct 14th)

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

What is the Credit Crisis Part 2: The COLLATERAL

Why didn’t the banks just change the terms of the loan?

Banks couldn’t change the terms of the loans because, in most cases of sub-prime loan debt, the original mortgage lenders no longer owned them. The original mortgage lenders had packaged up the mortgages they owned and sold them to other banks, to investment banks and to hedge funds as Mortgage Backed Securities (source).

What is a Mortgage Backed Security?

A mortgage backed security (MBS) is a type of asset backed debt security.

Recall that debt securities (ex: bonds) represent a type of security which must be repaid by the issuer: if a company issues bonds, it must come up with the money to make the interest payments, and the money to pay you the full value of the bond once the bond term has ended. This is different from equity securities (ex: shares of a company), in which there is absolutely no obligation by the company to pay you anything (though some do in the form of dividends to sweeten the deal).

The key part of a MBS is understanding that it is a form of debt security: whomsoever packages up these loans and sells them is promising the buyer that the issuer has money coming in to make sure the mortgages backing their investment do not default: this cash flow depends on average people making their mortgage payments on time and not defaulting on their loans.

How were the banks able to sell all these mortgages?

Here’s what happens: oridinary people take out loans from their local bank. The bank can package up these loans into mortgage backed securites. The MBSs are then put in a portfolio called a Collateralized Debt Obligation (CDO) with other asset backed securities. For a detailed look at how MBSs and CDOs work, you can check out this interactive presentation by the Washington Post (it’s slightly more complicated than I’m letting on, for example, I have elected not to talk about things like “tranches”).

CDOs are then sold by the local bank to investment banks, with the local bank earning a fee or a commission with every sale. The investment bank now owns the mortgages of the ordinary people, and in essence their mortgage payments go to the investment bank instead of their local bank (the payments may go through the local bank on the way to the investment bank, again perhaps earning transaction fees and commissions along the way).

The investment bank then sets up a corporation, called a Special Purpose Entity, whose cash flows are entirely dependent on the mortgage payments of ordinary people.

What is the purpose of a Special Purpose Entity?

The “special purpose” of this “Special Purpose Entity” is simply to sell investors the CDOs. The issuing investment bank earns transaction fees on every sale, and also earns management fees for the life of the investment (think of how a mutual fund company operates). Think of it as a company that doesn’t sell anything or provide any service: this company’s revenue comes entirely from the mortgage payments of ordinary people. 

Buying a CDO from a Special Purpose Entity is very much like buying a bond: you’re buying a promise of steady cash flow from the issuer. You’re investing because you believe that people will make their mortgage payments, and that by buying a CDO with a huge number of mortgage backed securities in it, a little of that expected cash flow from all of those mortgage payments made by ordinary people will trickle down to you (once it has passed through the hands of the bank, the investment bank, and the special purpose entity, each taking their cut).

What happened to the CDOs when people stopped making mortgage payments?

When ordinary people were unable to make their mortgage payments, the mortgages themselves became worthless: they became loans that no one could repay, and due to the downturn in the price of housing, even if the bank could sell the house, they’d likely have to do so at a loss.

When the mortgages became worthless, the mortgage backed securities became worthless, as there was no longer a steady cash flow from people making their mortgage payments. As the mortgage backed securities became worthless, many CDOs that had invested heavily in MBSs also became worthless. Anyone who had invested in CDOs now saw part of, if not all, their investment become worthless.

You may not consider that this would have much of an impact, and indeed it probably wouldn’t if CDOs were only sold to individuals. But they weren’t. CDOs were sold to institutions who put them in their hedge funds, in their pension funds, in their endowment funds. Unfortunately, CDOs were also sold to other ordinary banks.

And that was the real problem: the banks incurring such heavy losses. The economy doesn’t care if a company’s pension fund takes a nosedive or if a college’s endowment fund is down, but the economy does care if banks suddenly have worthless assets.

Why? Let’s find out in Part 3: The CRUNCH! 

For More Information:

For a very detailed look at how CDOs work, check out this interactive presentation by the Washington Post

Youtuber “Khan Academy”, a Harvard MBA graduate, has an very interesting (though occasionally quite confusing) series of videos on Mortgage Backed Securities (in three parts) and on Collateralized Debt Obligations. 

A Note About This Article:

N.B: This was probably the most complex of the four parts of BTG’s Credit Crisis series, simply because the subject matter itself is complicated (mortgage backed securities? collateralized debt obligations? huh?!?). I have elected to do a broad overview rather than get into very specific details about each item: for example, I don’t discuss the splitting of CDOs into “tranches” (the french word for “slice”). For those who are interested in more details, I have included resources above, under the heading of “For More Information”.

This post was included in the 174th Carnival of Personal Finance, hosted by  Greener Pastures

Part 1: The Credit - Part 2: The Collateral - Part 3: The Crunch - Part 4: The Crisis

Free from broke inspired this post, with one of his: Personal Finance in One Simple Equation, in which he demonstrates how spending less than you earn is a cornerstone of wealth building.

It’s a great post, and I could not agree more, but the math nerd in me was a little disappointed. From the title, I was expecting an actual established mathematical formula. Indeed, I already thought I knew which one he would be talking about!

I was looking for an article about The Compound Interest Formula.

Why? Because the compound interest formula is one of the most powerful mathematical concepts that I know of. Not only that, it is simple to use, and has the power to make your rich. I learned about this in my first ever finance class, and it’s changed my life. 

The compound interest formula looks like this:

I know, I know, it LOOKS hard, but it’s not.

Let’s break it down piece by piece:

FV : Future Value - This is what your money will be worth in the future, ie: this is your money’s future value, given the present value, the interest rate earned and the amount of time your money is left to compound.

PV : Present Value - This is the amount that you start with (your initial investment), ie: this is your money’s present value. This amount will earn interest at given rate r, for a given amount of time.

r : Annual Interest Rate - This is the interest rate that your money will be earning. When you plug it into the formula, express this as a decimal.

m : Number of compounding periods (also represented as n in some books) - interest can be compounded yearly (m=1), monthly (m=12), daily (m=365 or 360), even continuously.

r/m : Annual interest rate divided by the number of compounding periods - Because interest is compounded differently depending on the number of compounding periods per year, this will give you the proper rate at which your money is compounding per period. Fro example, if r = 10% and m = 12, your money is compounding at 0.00833% per month. 

t : Time in years your money will be compounding

mt : number of compounding periods x number of years your money will be compounding - because we split the annual rate in r/m, we need to multiply the number of years by the number of compounding periods in order to get the right answer.

So now that we understand the formula, let’s look at some examples:

Example 1 - You invest $1000 at an 8% annual interest rate. If interest is compounded monthly, how much money will you have in 5 years?

Break it down: PV = $1000, r = 0.08, m = 12, t = 5

Plug it in and SOLVE!

Example 2 - You invest $500 at a 6% annual interest rate. If interest is compounded quarterly, how much money will you have in seven years?

Break it down: PV = $500, r = 0.06, m = 4, t = 7

Plug it in and SOLVE!

Example 3 - You invest $750 at a 10% annual interest rate. If interest is compounded daily, how much money will you have in 20 years?

Break it down: PV = $750, r = 0.10, m = 365, t = 20

Plug it in and SOLVE!

See? That whole crazy formula isn’t so bad once you know what everything stands for!

Try making an example of your own life! Say you have $100 to invest. Try manipulating the different variables: try different interest rates, compounding periods, and number of years to invest.

So How Will This Make Me Rich?

Compound interest will help make your money grow. The goal is to get your money growing such that it outpaces inflation, and then some. Understanding how compound interest works, which means understanding how the formula works, is crucial to becoming financially educated and independant. Before I understood about compound interest, I thought I was rolling in it earning 3% per year from a GIC. It was only when I started learning about inflation and compound interest that I realized just how much money I was losing out on (by earning low returns, and by WAITING to invest), and how much money I could potentially make!

Cool Stuff You Can Try:

Try keeping everything the same except the interest rate (r) . You should notice that the higher the rate of return, the more money you will earn. In addition, the more frequently the interest is compounded, the more money you will earn over time.

Try keeping everything the same except the number of years you have to invest (t). You will notice that the longer you have to invest(say t=40 years versus t=30 years), the more money you will have. this should teach you, beyond a shadow of a doubt, to start your money compounding early! For more information, click here to read BTG’s Compound Interest Article: Time is Money Friend!

What Is A Credit Card Cash Advance?

A credit card cash advance is a way to get cash from your credit card. This can be used in cases when you have no cash or debit card, and the retailer does not accept credit cards.

How is it done?

A credit card cash advance can be done at most ATMs. In the options screen, there may be an option to “withdraw” from your credit card, or it may even be labelled as “cash advance”.

Say you wish to take a cash advance from your card in the amount of $20. The ATM will charge $20 to your credit card (which will show up on your next bill just as any other purchase would) and give you cash, in our case, a $20 bill. Now you can pay the retailer for your sweet comics!

Though my example makes cash advances seem innocuous, credit card cash advances are generally a very, very bad idea. There’s two reasons why.

So…What’s the catch?

There are two, and they are IMPORTANT. Credit card cash advances are bad ideas for two reasons:

1. Fees
2. Interest charges

1) Fees:
Most, if not all, credit card issuers will charge a fee for cash advances. These fees can be calculated in three ways:

1. Percentage Fee - The fee will be based upon a percentage of the amount of the cash advance. If the percentage fee is 5%, for example, a $20 cash advance will cost you $1 in fees.
2. Flat Fees - The fee is a “flat fee” regardless of the amount of the cash advance. In this way, they are much like the fees you would pay at an ATM: regardless of the amount of money you take out, you’ll usually pay the same flat ATM fee of a few dollars. If, for example, your credit card issuer charges a flat $10 fee for cash advances, then you’d have a $10 fee for your cash advance regardless of whether you took out $20, $40, or $200.
3. Combination Flat and Percentage Fee - This combination usually results in higher fees than the percentage or flat fees alone. In such cases, there may be a minimum flat fee (ex: ten dollars), but if the cash advance is in an amount whereby a percentage fee would give the credit card issuer more money (ex: more than $10), then the percentage fee would be used and charged to you instead. For example, if you only advanced yourself $20, at a 5% percentage fee, you would likely be charged the flat $10 fee (the card issuer would make $9 more this way). If you advanced yourself $220, the fee would be calculated using the percentage method (for a total fee of $11, $1 more than you would pay on a flat fee).

2) Interest charges

Credit cards can carry different interest rates for different uses of the card. Take, for example, the Capital One Gas and Grocery card, which I discuss in my analysis of 7 Canadian cash back credit cards, which illustrates three different categories of interest rates.

Notice the cash advance category: in this case it is set at 19.8 percent (coincidentally the same as the rest of the interest rates offered on that card).

Be aware that interest rates on cash advances can, and usually are, higher than the normal interest rate on the card.

In addition, cash advances are NOT like your credit card: with your credit card, you are generally given at least 30 days before payment of the balance is due. This means that on a credit card, you have usually 30 days to pay off your balance before they start charging interest.

This is NOT the case with cash advances: with a cash advance, interest begins accruing IMMEDIAELY, from the moment you take the advance. Many people do not realize this, and are surprised and shocked to find this out only when the bill comes some time later, by which time the interest has begun to add up.

So, should I take out a Cash Advance?

NO: the combinations of fees and interest charges make cash advances an extremely expensive way of getting quick cash. The example at the beginning of this article, buying comic books, was my first and last experience using cash advances. Cash advances are unsuitable for anything but the most severe cash only emergencies, and even then you should always look to your emergency fund first.

If you find yourself NEEDING to take out cash advances, you’re doing something wrong. You are either using the cash advance from your credit card to buy unnecessary things (ex: comic books, lunch, drinks, etc…) or you have a serious money management problem. Consider consulting a financial planner, and using BTG’s Excel Budget Template to figure out where your money is going every month.

For more information:

Financial Consumer Agency of Canada - A great government run website with multiple numerical examples of how fees and inetrest rates add up on a cash advance.

Credit Card Cash Advance Pitfalls @ Youngmoney.com - A neat site that explains the above somewhat more concisely.

Personal Finance by Kapoor et al. - Great book which details many things about credit cards, including cash advances.

Slice.ca - Til Debt Do Us Part - Full episodes of a great show that deals with debt repayment and money management.

What is an emergency fund?
An emergency fund is an account with money in it that is to be used only in an emergency. You should have access to the money in the account at all times, but you must be disciplined enough not to touch it unless it is really necessary.

What’s an emergency?
An emergency is any bill or cost you weren’t expecting, and/or would not be able to afford to pay normally. Some good examples include:

• unexpected medical bills (follow the link for a post about my $925 medical scan!)
• a problem with your car
• needing to replace an appliance or other item quickly
• legal/professional fees
• unexpectedly high bill for utilities/cell phone/internet/whatever
• job loss 
• moving costs  (thanks Flexo!)
• death / disability (thanks LivingAlmostLarge!)

 
Why do I need one?
Poop happens. Random, weird stuff happens at random, weird times, and all the planning in the world cannot account for all the randomness of the universe. Establishing a good emergency fund won’t protect you from all the unexpected financial hardships you’re likely to encounter, but it will in most cases be enough to smooth you through life’s rough patches. 

How much should I have in my emergency fund?
In total, your emergency fund should hold at least 3-6 months full living expenses. The “original” purpose of an emergency fund was to provide a financial cushion when people lost their jobs. Frankly, I’d prefer 6 months rather than three. Living expenses include everything from rent/mortgage to utilities to food to car/cellphone/cable payments: it is literally all the money you would need in an average month, times 6.

I also like to tell people that in addition to those 6 months living expenses, they should probably try to add another $3000 - $10,000 to their emergency fund.

The reason is this: what happens if you encounter an unusual financial hardship while you’re out of work? If your emergency fund only has enough for your living expenses, and something weird happens, you may not be able to pay for it. So I like to tell people to work on adding at least $3000- $10,000 extra to their fund (especially if you’re in the United States where healthcare costs are so high), which will cover the cost of the unusual financial hardship, and still keep your 6 months living expenses intact.

Can I have more than one emergency fund?

Absolutely!  If you anticipate other specific emergencies, set up a separate emergency fund just for that, so that you won’t have to dip into your main fund. For example, if you have a car which you suspect will require maintenance at some point in the future, set up a fund specifically for your car. This is a seperate account from your main emergency fund holding your 3-6 months living expenses. With ING it’s easy to set up sub accounts, and to name them to reflect their specific purpose. Click here for BTG’s ING subaccount tutorial.

What kind of account can I use for my emergency fund?

You can use any bank account for your emergency fund, but many people choose to open one with an online bank like ING direct for several reasons:

1. The money will be sitting there between periods when it is needed, so you may as well earn a little interest on it. Online banks tend to offer higher interest rates.
2. You don’t want account fees eating into your emergency funds. Online banks tend to have much lower fees. Some even eliminate them entirely.
3. It can take several days to transfer funds from the online account, which is good if you are impulsive with your money. Having to wait for the funds for a few days means you’ll be less likely to dip into your emergency fund for impulse buys. If you need access to emergency fund very quickly though (say less than 6 days), you should keep it in a normal bank account that you can access quickly.
4. It’s very easy to set up automatic deposits into an emergency fund.

How do I start an emergency fund?

1. Consider your needs. If you think you will need access to the emergency fund quickly, consider using a  low fee savings account from a traditional bank. If you think you could afford to wait a few days for the funds, you’re better off with a high interest, no fee savings account from an online bank.
2. Find a bank that you like. Shop around. I like ING, but there are many other banks to consider. Consider fees, interest rates, and ease of use.
3. Open an account at the institution you’ve chosen to house your emergency fund.  
4. Set up automatic deductions from your regular bank account to your new emergency fund. Online banks tend to make this very easy, as do some regular banks. Call your bank or look online to find out how to do this if you are unsure.
5. Sit back and relax…you’re on your way to financial independence!

How long will it take me to complete my emergency fund?

Remember, Rome wasn’t built in a day: Emergency funds can hold a substancial amount of money, and this takes time to accumulate. The earlier you start, however, the sooner you’ll get there. Even having a little bit of money set aside for emergencies is better than having no money set aside for emergencies.

Heck, if you drink soda, you can start by putting away as little as 2 dollars a day, which can add up to thousands as time goes on.

Now it’s your turn! Have I missed anything? What has your experience been with emergency funds? Post your horror/success stories below!