It's good for banks - and just as good for your personal finances.

"Stress testing" your household budget can help you avoid being blindsided by an unexpected financial hit. The idea is to model how various worst-case scenarios would impact your balance sheet. For example, consider what lifestyle changes you would need to make if any of these happened:

  • You drop from a two-income household to one.
  • Your family experiences a complete loss of employment.
  • A natural disaster adds to your expenses.
  • Catastrophic illness results in substantial medical bills.

Fortunately, modeling these what-ifs is fairly straightforward, using a simple spreadsheet or some basic budgeting software to run the numbers.

Step 1: What Would You Owe?

Start by triaging your finances to figure out what would need to be paid — and what could be deferred. Nationally syndicated consumer advocate Clark Howard advises that your mortgage should always come first, followed by your transportation costs (auto lease or loan) so you can get to work and keep earning. Next, look at any discretionary payments you could cut — maybe you're making extra payments to whittle down a home equity line or making monthly IRA or 401(k) contributions. If you have employee-paid health benefits, you may need to factor in the cost of COBRA coverage. In the case of job loss, you would typically pay the entire premium amount (i.e., the portion that you paid as an active employee plus the amount your employer contributed) to continue coverage.

Step 2: What Would You Have?

Don't count on unemployment benefits to save the day. The average unemployment check is around $295. The average weekly salary it replaces? $865. Consider alternative sources of income, such as borrowing from your 401(k) or tapping a Roth IRA, which generally allows you to withdraw your initial contributions (though not your earnings) before retirement without taxes and penalties. You might also consider breaking into college savings accounts, if necessary, even if you incur taxes and penalties. After all, borrowing to send a child to school is still reasonably easy. Finally, consider credit capacity. Since your credit will dry up as your financial situation worsens, know what you can tap now — personal lines of credit, home equity, credit cards, etc.

Step 3: Prepare for the Worst (and Hope for the Best!)

More than anything, planning for the worst gives you a better sense of your financial standing, including how long your emergency reserves would sustain you. Of course, if your finances can't stand the "stress," you'll want to look at building a better safety net.

To learn more, please call (888) 804-6450.