Your emergency fund is foundational to any financial plan. Here I discuss what it is (and what it is not), why you need to have one, and how much should be in it. Also included in your financial foundation are wills, trusts, living wills, and guardianship arrangements, as well as basic insurances. Even if you are already retired this is just as, if not more, important.
The emergency fund – planning ahead
An economics professor once said that if you fall asleep in class and he calls on you just shout out, at the margin and you’ll likely have the right answer. The entire study of economics is about what happens at the margin: the next unit of production, the next unit of income. Think about it: bankruptcies happen when there’s just one dollar more due that you simply cannot pay. So in talking about an emergency fund, we’re talking about what happens at the margin of your financial life. You’re keeping cash set aside to make sure that you’ll never get to that point where you don’t have the next marginal dollar.
What’s an emergency fund for?
Emergencies happen in life: this is not a matter of whether but of when. Unexpected expenses happen to all of us, and always at the worst possible time. Say you get into a car crash and you need to pay a $1000 deductible. That’s an emergency. But say that same car needs new tires. That’s not an emergency – it’s a routine maintenance that should already be anticipated in your budget. You just brought home $200 worth of meat from Costco and your freezer decides to stop working. That’s an emergency.
I’m sure we can all come up with a few examples of times when an extra few thousand dollars in the bank would have made a big difference.
How big should my emergency fund be?
You should have anywhere from 3 to 6 months of bare bones expenses to run your household in your emergency fund. Three months would be fine if your household has two earners, earning similar incomes. Six months should do it for a single earner household.
The bottom line is to err on the side of caution: have more rather than less. Think about this: What happens if you lose your job? Most of us would cut our expenses back until it hurts. You’ll clean your own house and cut your own grass. You’ll stop going out to eat. You’ll be pinching pennies out of necessity and do your best to ensure you have enough left in the bank.
An emergency fund protects long-term investment assets and prevents debt
Build up your emergency fund now and you will be very glad you’ve disciplined yourself and put that money aside. Not only will this fund keep you afloat, but it will also keep you from going into debt. It also prevents you from touching your long-term investment assets.
Now – where do you keep an emergency fund?
Let’s make a distinction here between savings and investment. Building up your emergency fund is savings – so the short answer is to keep it in the bank. You’ll earn next to no interest at the bank, but that’s not the point. The point is to not lose anything. You’re counting on this money to be there for you when you need it most. I distinguish between investing and saving in that investing is putting your money out there at risk for the long-term with the expectation of a gain. Markets are volatile, but the trend over time is upward. If funds are invested in markets, this is not an emergency fund.
Here’s the risk of investing your emergency fund dollars in markets: say you have a $10,000 emergency – you need a new A/C system – and that’s the amount you’ve maintained in your investment account. But the market is undergoing a correction – down 20%. What’s now on hand? Your $10,000 account is now worth only $8000. So save this money at the bank – don’t invest it in financial markets.
The emergency fund and your budget
The emergency fund works hand-in-hand with your written budget. That’s a topic for another post. For my own emergency fund, I opened up a separate savings account at the bank and set up a monthly automatic transfer. At the end of the month I can decide whether to manually add more money to savings or not. At the very least, I am in the habit of adding to or replenishing the emergency fund consistently over time.
How are you maintaining an emergency fund? Do you have a cushion in place when emergencies happen? Be sure to check my video (below) on what you need to know when building up your emergency fund. To learn more about this and other foundational financial planning topics, check out the CameronDowning website. Also connect with us on Facebook, Linkedin, and Twitter.