Emergency Cash Is a Necessity, Not a Luxury

A dismaying 31 percent of respondents to a Lawyers.com survey reported that their liquid savings wouldn't cover their living costs for one month. Just one month! And 45 percent said their cash stash wouldn't cover the regular bills for three months.

I don't care how healthy or young you are, or how financially stressed: You need an emergency cash fund, and you need it now.

It's wise to eventually build up a six- to eight-month fund, because there's a good chance you won't earn a paycheck for at least that long if you're laid off or become too sick to work. Even if you have disability insurance, it often doesn't kick in for the first six months of your disability.

Nevertheless, more than 80 percent of the respondents to the Lawyers.com survey don't have a cash fund that would cover their living costs for at least six months.

Compounding the Problem

Let's face it, even relatively "small" emergencies can send your finances into a tizzy. An unplanned medical test or two can quickly add up to a four-figure doctor's bill even if you have health insurance. Remember, insurers are working hard to shift medical care costs onto consumers as much as possible, and that means higher co-pays and reduced coverage for certain procedures.

Or say your house needs some serious unplanned repairs. Tapping into your homeowners insurance can backfire. First, you're going to have the deductible to deal with, so you'll need some cash regardless. And when you actually use the insurance, you're probably looking at a premium hike at your next policy renewal.

Consumers are also quick to pull out their credit cards to pay for unforeseen expenses. That's fine if you qualify for a no- or low-interest-rate card, but with the average rate at an obscene 15 percent, plastic isn't a smart solution for everyone.

Don't Bet the House

Using home equity to bail yourself out of unforeseen economic shortfalls can also be a very expensive solution. Thanks to the constant rise in the Federal funds rate, home-equity line of credit interest rates are now more than 8 percent for borrowers with excellent credit, and over 9 percent for those with merely good credit.

And those rates aren't fixed -- they change every time there's a change in the Fed funds rate. Even if Ben Bernanke and company at the Federal Reserve choose to stop raising the rates, no one is forecasting a rate reduction. Paying more than 8 percent to bail yourself out of an emergency, big or small, is too costly a strategy.

The same goes for borrowing from your 401(k) plan. I've covered this territory before, so here's a short-recap: The money in your 401(k) is pre-tax, meaning Uncle Sam has yet to take his cut. When you take that money out as a loan, you'll eventually have to pay it back, and that's going to come from money you've already paid taxes on.

Then, when you retire and start making 401(k) withdrawals, the same money you used to repay your loan is going to be taxed again; all withdrawals are subject to income tax. Paying taxes twice on your money isn't a reasonable strategy.

Besides, if your emergency is that you were laid off, you won't be able to take out the loan anyway. And withdrawing money outright from a 401(k) means you lose twice: If you're under 59 and a half, you'll have to pay an extra 10 percent IRS penalty for an early withdrawal, and you've just gutted your retirement savings.