Simple Alternative to the Extended Warranty

I usually advise people not to buy extended warranties on most items. They are a big money waster. Then the other day I read Flexo’s How to Create Your Own Extended Warranty on Consumerism Commentary and he pointed out a great way to afford repairs without getting suckered into an extended warranty.

I recommend that you read the article for his perspective on this topic which comes from his experience working at an electronics store. But here’s my cut-to-the-chase version of how to create a Warranty Fund. My version is slightly different since Flexo suggests that you create a separate or sub-account for each product. I would simplify this and create one warranty (or repair) fund that could be used whenever you need it for any item that breaks down.

Step 1. When you purchase an item, make note of the cost of the extended warranty. Don’t buy it.

Step 2. Transfer this amount to a special savings account that you will not touch until one of your “protected” items needs to be repaired. Coors Credit Union offers a “You Name It” Savings Account, which is perfect for the Extended Warranty Fund. This will build up a sizable Warranty Fund.

Step 3. When one of your self-insured products breaks or otherwise needs repairs, dip into your Warranty Fund.

Establishing a Warranty fund will help you avoid tapping your primary Emergency Fund unless the Warranty Fund doesn’t cover the full expense and the product must be fixed or replaced.

How much do you need for an Emergency Fund?

The answer to this question isn't all that straight forward. Suzy Orman says you need 8 months of living expenses socked away. Others say 6 months or even just a few thousand. Dave Ramsey says that you should shoot to have a minimum of $1,000 and no debt then build up to 3-6 months worth of expenses.

I like to look at emergencies in varying degrees. You should always keep $1,000 in your regular savings account. That's the cash you'll need if the car breaks down or the hot water heater quits. After that I'd go for Suzy's advice--start working on your big emergency fund and shoot for the full 8 months. A big emergency, of course, would be losing your job.

Sure, you may be eligible for unemployment benefits, but note that the pay is significantly less than your salary and does max out. For a bit of a reality check go to Colorado Internet Unemployment Claims Benefit ESTIMATOR to get an idea of what your unemployment benefits might be. And remember, these benefits are considered income and therefore taxable by the IRS. So if you think you didn't need that emergency fund, maybe you are now thinking twice. Oh, and don't forget if you lose your job, then you've also lost your health benefits and will now have that added expense.

As part of your emergency preparedness take a hard look at what your expenses might be if you lost your job. Are there places you're prepared to cut or change? Could you:

• Eliminate--cable or dish services, video and gaming rentals, gym memberships, etc?
• Sell your some of your stuff?
• Rent out a room?

You should always have a plan in place, just in case. Meanwhile, 8 months of expenses is still a big chunk of change. You can only do the best that you can do. Can you establish automatic transfers from your checking to another account? When it's automatic your less likely to miss it, but if that $100 sits in your checking account it's more likely to be spent unnecessarily. Instead of monthly transfers consider splitting your direct deposit, so you double your money quicker.

According to a poll by Bankrate.com 4 out of 10 people don't have an emergency. These days you don't want to be one of the 6.

Where to keep an Emergency Fund

Yesterday I told you how Suzy Orman updated her 2009 Action Plan (you did get the free download, right?) to focus more on building and emergency fund and less is paying down debt. This goes against everything you've heard before, but in these uncertain times makes very good sense. But just what is an emergency fund? That is, what accounts should be included.

First the funds must be reliable, so that means they should be safe and insured. If you should lose income source you don't want to rely on something like stock investments that fluctuate dramatically from one day to the next. Actually, to be totally clear let's say NO STOCKS. Yep, I'm screaming, don't include stocks among your emergency assets.

The next qualification for an emergency fund is that it be readily accessible (a.k.a. liquid funds). It must be available when you need it.

So what accounts can be included in your emergency fund?

Savings Accounts: This is a no brainer. Savings accounts are simple, insured and easily accessible. It's a good idea to keep a secondary savings account for emergency savings. DO NOT set it up as your checking overdraft safety net. DO establish automatic deposits to keep it building.

Money Market Account: Again these are insured, but they also earn a higher interest rate than regular savings. However, they often have a minimum opening deposit. These accounts are nice because you can add deposits, withdraw immediately and they are safe.

Certificates of Deposit: Also insured and higher-earning, but they do lock up your money for a specified time period. However, early withdraw penalties are typically low.

What about your retirement funds? This one always carries a big debate. Yes, most people have a substantial amount of money in 401(k)s or IRAs, but these should only be used in extreme situations. Don't go about your days thinking your covered by these accounts. The penalties for withdraw or loans against your retirement accounts are hefty. If you withdraw money from your 401(k), you are going to pay taxes on the amount your withdraw plus penalties. It may also throw you into a higher tax bracket and cost you more in taxes on the rest of your income. Withdrawing $10,000 from your retirement will cost approximately $3,000 in taxes plus another $1,000 in penalties. Taking a loan against your 401(k) is also dangerous, you'll have to pay it back and you can't take a loan if you aren't working.

To withdraw funds from your IRA you must be:

• Contributing for 5 years
• Age 59 ½
• Disabled
• Qualified “first-home” purchase (a withdrawal of up to $10,000)

Withdrawals for any other reason are considered nonqualified distributions and may be subject to income tax.

How about credit cards or home equity loans? Using debt accounts for emergency shouldn't be part of your plan. However, if the emergency arises and you don't have cash funds to use, then you'll need to turn to credit. Racking up debt while working through a loss of income is not only costly, but adds stress. That said, it is a good idea to pursue a home equity line of credit if you don't currently have one. Unlike a home equity loan, a line of credit only needs to paid back if you use it. But, falling home values are making home equity lines of credit harder to come by, and so, it's a good idea to apply before you actually need it. Keep a home equity line of credit and a low-interest credit card in your back pocket for when things get really rocky.