Take some time to prepare your budget for disaster

Those of us prone to financial daydreaming spend a lot of time on the lottery fantasy. We create elaborate Excel spreadsheets in our head sorting what we would buy if we won, whom we would help and when we'd retire. But few people spend enough time imagining the nightmare case.

As Elizabeth Warren, a Harvard University bankruptcy expert, and her daughter, Amelia Warren Tyagi, note in their book, "The Two Income Trap," disaster is the defining theme in the financial lives of millions of Americans.

So forget about the jackpot for a moment and consider its opposite. The authors suggest conducting a financial fire drill, in which you plot how you'd face down the worst-case scenarios.

They're not the only ones recommending such an exercise. The drill has become a component of Kevin McKinley's financial planning process at his firm, McKinley Money in Eau Claire, Wis.

What follows is some guidance for conducting your own financial fire drill. McKinley has a number of eyebrow-raising suggestions. They include borrowing before using up savings, using any accumulated assets to pay the loans back as slowly as possible.

For a gut check, I also turned to Kathy Santos. A 53-year-old Web designer who lives in Pepperell, Mass., Santos spoke about diversifying her income through freelance projects and work as an emergency medical technician. The next month, she lost her full-time job and had to quickly consider her own financial disaster plan.

Most people in financial trouble would be inclined to turn to their emergency funds first, before taking on new debt. But the financial fire drill is planning for extreme circumstances, which means that most of the following advice is not intended for everyday use:

START WITH SPENDING: An obvious first step in the fire drill is to contemplate how you'd cut back spending if all or part of your income disappeared. Scaling back before the worst happens makes intuitive sense, though many people can't bring themselves to downgrade their lifestyle unless they absolutely have to.

The pain of a collapse in income, however, would be much less if you had already excised some of the extras that turned up in the drill.

"It's a leveraged advantage to cut spending," McKinley said. "Not only do you live on less, but you accumulate more to serve as a safety net."

The list of budgetary line items to consider should be familiar enough by now -- eating out, vacations, household utilities and the like. But McKinley tends to focus on automobiles, an area that doesn't come up as often.

"People who have their heads on straight about money typically have little or no car payments," he said. "They drive cars until they drop."

McKinley, who drives a 2003 Honda Pilot with 80,000 miles on it, suggests flares, blankets and a backup cell phone for those who worry about car trouble.

Santos and her husband seem like guilty parties here because they have three cars. Indeed, selling her husband's sports car was first on her fire drill list.

CONSIDER BORROWING: McKinley's most radical notion is to use the drill to assess your borrowing capacity. You do that in anticipation of taking out loans before spending much savings.

"You borrow money when you can get it, then pay it back out of assets as slowly as possible," he said.

The logic here is that available credit, whether it's a home equity line or credit cards, can disappear at any moment. It's vanishing, in fact, with increasing frequency for all sorts of people who are still employed. So if it's clear that your financial situation is dire, the theory goes, better to tap the credit while you can.