Emergency Fund Essentials
Recently, a wayward rock found my daughters windshield and a large (and growing) crack ensued. No one did anything wrong – it was just one of those unanticipated things that pop up in life from time to time. After some calling around to find the best price, we had the windshield replaced. No big deal.
Of course, what made it no big deal was that we had funds set aside for just such an occasion. The episode was more of an inconvenience than a full blown emergency, but it reinforced the importance of having funds for such unplanned situations.
The emergency fund is a financial topic that is far from exciting, but oh so important. Let’s face it, earning fat profits in your investment portfolio, finally paying off that zombie loan (you know what I mean, that debt that just wouldn’t die!) or cutting your spending by a grand or two a monthly are much more exciting.
How exciting is it to say, “Hey guys, I just saved another $200 in my emergency fund that I hope to never use! Oh, and I’m earning a big, fat 1% on it while I’m waiting to NOT use it!”?
While this may be true, the boring things in life need to be handled, too. So let’s talk about emergency funds.
What is an emergency fund, and why do I need one?
An emergency fund is simply an amount of money set aside for emergencies that may arise. Pretty obvious, huh? While the exact nature and timing of an emergency is unknown, we can be certain that one will eventually arise. It would certainly be nice to have funds set aside to deal with it quickly and easily.
Why are emergency funds so important? One of the principles of sound financial management is being as prepared as possible for the unexpected. If you don’t have funds set aside, when the need arises, the temptation will be to use credit to meet the need. Think about it: When an emergency hits, the last thing you need to do is go into debt! Sadly, many Americans struggle with funding an account for emergencies. Bankrate.com reported earlier this year that only 38% of Americans could pay for a $1,000 emergency expense with available cash. The remaining 62% would have to borrow the money or cut their spending elsewhere!
Consider your emergency fund as a form of insurance – insurance against getting hit with a loss that disrupts the bigger goals you have set for your financial life. Yes, the earnings on this fund will be small, but it’s not an investment – it’s insurance.
When should I fund one?
If you have consumer debt like credit cards, car loans, and the like, I generally like to pay those off as quickly as possible. Taking the time to first set aside a large emergency fund will probably slow that process down significantly. This, in turn, will possibly cost you significant additional interest charges and significantly push back any “debt-free” goal you may have in mind.
Even if you are in consumer debt, I like the idea of having at least some minimal amount of cash set aside, readily available, for any emergencies that come up. Again, you don’t want to add to your consumer debt at the same time you’re trying to pay it off! How much is a minimal amount? Something in the neighborhood of $1,000 to $2,500 should be sufficient.
Where should I keep it?
Your emergency fund should be kept separate from your regular operating funds, but still be readily available if needed. In other words, don’t keep it in your checking account, but don’t tie it up somewhere it can’t be quickly accessed.
Keeping it too handy, like in your checking account, can make it too easy to spend on a whim. As strange as it may sound, having a pizza delivered during the big game on TV isn’t an emergency! Neither is a new pair of shoes.
In our situation, we use an on-line, FDIC-insured money market account linked to our checking account. By using an on-line bank, we can get a higher interest rate than a “brick and mortar” bank (not that either are paying much right now). Should we need some of the funds, an on-line transfer can be entered and the funds will appear in our checking account within two days. That is quick enough to handle most emergencies, but slow enough to prevent spur of the moment purchases.
Others may choose to keep their emergency funds in certificates of deposit or savings accounts. I’m OK with using CD’s as long as you remember you’ll probably incur a penalty if you need the money before it matures. Do NOT invest it in the stock market. Yes, I understand you want higher returns, but the market may crash just as you need the money. At the very time you need it, it may lose half its value. Remember: it is insurance, not an investment!
How much should I have in my emergency fund?
Here’s where it gets more complicated. Well, not complicated really, just more case specific. It’d be easy to rattle off some theory like “just have three to six months of expenses”. But for most of us, that’s a pretty big range! So, how do you know?
First, let’s define “expenses” for emergency fund purposes. I believe expenses should be limited to the essentials and should exclude the discretionary.
Here are some examples of each:
Now that we’ve defined the types of expenses to be included in our emergency fund calculation, let’s consider how many months of these expenses we’ll need.
It can be tempting to simply say, “I’m conservative, let’s go with six months.” Or to say, “Let’s roll the dice and go for only three months.” But a reasoned answer can be learned if we examine our own personal situation.
To help you narrow that range, here are some questions to ask yourself?
(1) Do you have multiple income streams, or just one client/job? For example, when I was a full-time freelance CPA, I had multiple clients. If I lost one, I still had the others. The odds of me losing all of them simultaneously was small. While my income may drop, I still had my other client work to fund my expenses while I was looking for new clients. Maybe you have a second job, or a rental property with positive cash flow – these would be multiple streams of income.
(2) Is it easy to find a new job in your work field? For example, as a CPA, there are always opportunities available. It may be in a new industry, or with different responsibilities, but generally there are accounting related jobs available. If, on the other hand, I was an astronaut, it’s reasonable to assume it would take me longer to find a new job in my field.
As you can see, there is no universal answer, and each person who reads this post will answer these questions differently. But when the answers are tallied up, you can get a feel for whether you should have three or six months, or maybe something in between.
Consider the opportunity cost of over funding
We’d all probably like the idea of having a big wad of cash sitting available when financial trouble arrives. But make no mistake, having an emergency fund costs you money! Those are dollars that could be used to pay off debt, or could be invested in a product with a higher expected return (which in today’s interest rate environment is just about anything!).
Let’s see how too large of an emergency fund can slow you down in meeting your financial goals. Imagine you bring home $5,000 per month, and your monthly expenses are $4,500. First of all, congratulations, you have a positive monthly cash flow! Now imagine you are starting with zero saved and are going for an emergency fund of six months of expenses.
Here’s the math: monthly expenses $4,500 x 6 months = $27,000 needed – at $500 per month, it would take 54 months to save a fully funded emergency fund! That’s four and a half years! It may be worth it (depending on your exact circumstances), but then again, it may not. You’ll have to answer that question for yourself.
You will need to find the balance between the positive benefits of having “emergency” insurance and the negative opportunity cost of lost earnings on those dollars.
I’m convinced that having an emergency fund is important for all of us. The peace of mind that comes from knowing that a cracked windshield, flat tire or broken microwave won’t force us to turn to debt (via a credit card) to resolve the problem. In fact, I’ve noticed that when you’re prepared for emergencies, you tend to have less of them! Maybe it’s just because they don’t feel like “emergencies” anymore simply because you were prepared!
We don’t need to accept some arbitrary rule about how much to save. There is no “one size fits all” emergency fund size. By going through the exercises described above, we can each calculate the size fund that’s just right for us and our family. If you have any questions, please let us know!