The Importance of Emergency Funds
- Written by Candice Elliott
Having an emergency fund is one of the most important things you can do. Today we’ll discuss the importance of having an emergency fund.
There are a handful of things that can be considered personal finance 101 and having an emergency fund is one of them.
What is an Emergency Fund?
An emergency fund is a pool of liquid money set aside for unforeseen expenses like a medical expense or a car repair. Having an emergency fund can be the difference between a small bump in your financial life and complete disaster in your entire life.
An emergency fund insures against life's unexpected expenses.Tweet This
Having a robust emergency fund gives you peace of mind. No one wants to live one paycheck away from not being able to pay the rent or one car breakdown away from not being able to get to work. It also gives you some freedom.
If you decide to leave a relationship or your job becomes so unbearable that you have to leave before finding another (something you should only do in really dire circumstances) or you want to go back to school or start your own business, having an emergency fund gives you the freedom to do those things.
Keeping that money separate from the money you use to pay bills can help curb frivolous spending. Sometimes when you see a big number in your checking account you get a little cocky and a little more reckless. Keeping the money separate can help you avoid temptation.
What is an Emergency?
You should only dip into your emergency fund for a real emergency; to keep yourself afloat between jobs, for a car repair, a medical expense, or a home repair. You cannot use your emergency fund for things like a vacation, a shopping spree or to upgrade your perfectly good cell phone or laptop.
Ideally your emergency fund should be 3-6 months of expenses. That sounds like a lot and it is but keep in mind, that number can be your bare bones expenses. If you were to lose your job your spending would be (at least it should be) different than it is when you have money consistently coming in.
The number you use to calculate your three to six months would include expenses like rent, utilities, car payments, etc. It does not have to include dinners out, entertainment, and clothing expenses or saving for retirement.
How to Grow One
Even still, 3-6 months of basic expenses will still add up to thousands of dollars for most of us so it can be daunting to save up that much. But you don’t have to accumulate it all at once. Set a reasonable time frame to get to the six month number. Don’t give yourself too much time though. Growing your emergency fund should be a priority.
Let’s say your ultimate goal is $12,000. That means your bare bones expenses are $2,000 a month. If you saved $400 a month, it would take 2.5 years to reach that number. That’s a reasonable time line as long as you are saving that $400 every month.
Remember though, this is a priority. If you can throw an extra $100 a month in there, do it. Or you can use any “extra” money you get, a bonus, a raise, monetary gifts, to help you reach your number faster.
There are also a million ways to make some extra money on the side. Set up a store on BigCommerce and sell items you make, re-sell items you buy or go through your own things and sell them there. Spend one or two evenings a week driving for Uber. Get a few babysitting gigs on Sittercity. Americans spend five hours a day watching TV. You can use a few of those hours doing something more productive and lucrative.
I would always rather make more money than spend less but if you don’t have the time to do something to bring in extra money, there are also plenty of ways to spend less. Start by going through your Mint account.
Food expenses are always a likely culprit. Most of us spend way too much on food whether that means buying groceries, ordering take out, or going out to eat. Almost everyone can cut down on this category.
You’d be amazed at the deals and discounts you can get if you’re willing to spend a little time doing some research and making phone calls. Go to a site like Einsurance and compare home, life, health and car insurance rates. There is so much competition that you can almost certainly get a better deal than you have now.
How high is the interest rate on your student loan? SoFi or Lendkey may be able to lower it for you which not only saves you potentially thousands of dollars in interest but you will be able to pay it off more quickly.
If you’re paying off credit card debt that can really hamper your ability to accumulate an emergency fund. Look for a good balance transfer card. Some of them have a 0% APR introductory rate for up to 24 months. You can roll the balances from your existing cards to the balance transfer card and it allows you to pay only the principle with no interest so you can pay the debt down more quickly.
If you can’t get a balance transfer card, call up the credit card company and ask them to lower your interest rate. They aren’t going to drop it down from 17% to 2% but even a small reduction in interest helps.
How many of the dozens of cable channels that you pay for do you actually watch? You probably just watch a handful of shows. Could you watch those same channels through Hulu or Fubo or HBO Go? Several of them combined are cheaper than paying for all those cable channels every month.
What do you buy regularly? Things like toothpaste, toilet paper, and cleaning products can be purchased through Subscribe and Save on Amazon. They are cheaper, you can schedule the shipments so you never run out, and you don’t have to spend time shopping for them.
Sign up for Trim . It will go through your transactions and alert you to any recurring charges. If those charges are things you forgot you were paying for like the hosting fees for the blog you never really got off the ground or things you could cut out to save a little extra like magazine subscriptions, the company will cancel them for you.
Where Should You Keep It?
This is a controversial subject. Some people reach for the smelling salts when it’s suggested that an emergency fund is kept anywhere but a checking or savings account. And that’s understandable. This money needs to be kept where it can be quickly accessed and where it will be safe. It’s reasoned that if you invest this money it may decline in value when you need it because of market volatility.
But what is safe? Your money isn’t safe from inflation in one of those low yield accounts. Inflation averages 3% and most checking and savings account pay less than 1% interest. So year by year, you’re losing money.
What $1 can buy today will take $1.03 to buy in one year. Three cents isn’t anything to worry about now but if you had that same $1 to spend in 1997, you would need $1.53 to make the same purchase in 2017. Now imagine not only are we looking at 20 years but thousands of dollars.
If we use our $12,000 emergency fund number from above in the year 1997, in 2017, it would take $18,372.34 to match it. And some people will need a lot more than $12,000 to have saved six month’s worth of expenses.
What if you’re a baller and for you, that number is $60,000? Are you willing to have that much cash sitting in an account that is being nibbled away at by inflation? You will always have to keep topping up your emergency fund to keep pace with inflation.
It’s not just the loss of value due to inflation but the loss of growth when your money is parked in such a low yield account. So what can we do that protects our emergency fund both from inflation and market fluctuations?
Some financial writers advocate investing your emergency fund. Betterment recommends putting your emergency fund in a portfolio split between 30-50% stocks and the remainder in a diversified allocation of bonds. You could also invest your emergency fund in a Roth IRA where you can withdraw contributions (but not the growth) without penalty.
You want your fund to grow but you don’t want to keep all the gains it makes in that same pot because that additional money could be invested in a place where it will grow more quickly, like a fund set to a riskier allocation between stocks and bonds or your Roth IRA.
When your fund is 20% more than the 3-6 months worth of expenses it needs to be, transfer that 20% to a different investment account.
A checking or savings account is the most liquid place to keep your money. Betterment can take 3-4 business days to transfer funds. But if you have credit cards with a high enough limit, you could use that to pay for the emergency and pay it off when the funds transfer, paying no credit card interest.
Be aware that you may also have to pay capital gains taxes when you liquidate investments.
What About Credit Cards?
Some people depend on their credit cards as an emergency fund. This is not the best solution but depending on the circumstances it isn’t the worst either. If you have fluctuating income as freelancers or real estate agents do, you might not have all of the money to cover an emergency when it happens. You charge the expense on your credit card and pay it off relatively quickly when money comes in.
The end of the world scenario is losing your job, not being able to find one for weeks or months, having no emergency fund at all, and paying every expense on credit cards to stay afloat.
If You’re on the Fence
If you’re still not sure whether or not you should invest your emergency fund this may help you decide. If you can answer yes to these questions, the risk of investing your emergency fund are further mitigated.
Do you have more than one income stream? The greatest benefit of an emergency fund is the safety net it offers if you lose your job. Everyone is expendable these days and a lot of jobs will be automated in the future. That’s why you need an emergency fund but it’s also why everyone needs more than one source of income.
That source could be rental property, it could be dividend yielding investments, a side hustle or part time job. It doesn’t even have to be a ton of money coming in (although that would be nice), just so there is at least something coming in until you could find a new job.
Is your job secure? Again, no one is 100% safe but some of us have better job security than others whether that means you are secure in your role within a company, the company you work for is stable or the industry you work in is stable.
Is your job in demand? If you’re in a high growth industry that is specialized, even if your company went under, you would be able to get a job more quickly than someone in an industry with low demand.
Do you have a 401k? You can “loan” yourself money to cover the emergency and then pay it back. This is another controversial subject within personal finance but it’s not the apocalyptic scenario it has been made out to be. We covered this in depth.
Do you have a Roth IRA? As mentioned above, you can withdraw the principal from that for an emergency without penalty.
Money on the Table
It’s conventional wisdom that everyone needs an emergency fund but everything else surrounding the subject is open to debate. The minimum in your emergency fund should be three months, some people advocate as many as eight.
Should you invest your fund or leave it in a checking or savings account? It depends on how much risk you’re comfortable with but the level of risk that many people talk about is overstated. There is a happy medium between putting 100% of your emergency fund in stocks and losing money to inflation and leaving so much potential growth on the table by putting in a low yield savings or checking account.
Consider the options we’ve given and find the sweet spot for you.
Miranda Marquit: Miranda’s personal site.
Simple Wealth: Research and evaluate rental properties.