Lots of us have heard about an emergency fund. If you are one of those who is asking what it is or its purpose and fundamentals, or are really bothered by keeping a bunch of cash sitting idle, then read on.
What is an emergency fund and why do I need one?
An emergency fund is exactly what it means – a pile of cash sitting around that you can access for emergencies. What kind of emergencies? Well, the most common ones we have heard of are a job loss, health emergency, or a sudden major repair for your house or your vehicle. I am sure there are more but these tend to top the list. In recessionary times like 2008 or 2020, this starts to feel even more important. But in addition to serving as a cushion for emergencies, I also view this as a cushion for allowing me to invest more aggressively in the rest of my asset portfolio without worrying about temporary losses. Some people also call this the barbell allocation strategy where one one hand they invest in extremely risky investments and that is balanced by no risk investments like cash.
How much do I need in my emergency fund?
The answer for this is – it depends. Well, traditionally financial advisors will recommend between 3-6 months of expenses in an emergency fund. It depends a lot on your family situation. Are you single or married with kids? Is your family dependent on one income or multiple sources of income? If you are dependent on one source of income, you want to move toward the 6 month emergency fund. If you are a household with double incomes or multiple income streams, then the risk is obviously divided and you could afford to stay at 3 months. In recessionary times, people tend to get more conservative because they feel it might take much longer to find a new job and may try and keep a 9-12 month emergency fund. I personally moved toward a 9 month emergency fund this year in 2020. But ultimately, the answer is – its whatever allows you to sleep peacefully at night!
One obvious point to think about here is, if you reduce your expenses permanently then you don’t need as much money in your emergency fund. We talked about reducing your expenses in an earlier article. The other way to think about this is to think of your bare bones budget – meaning, if you lose your income, what would I be able to drop my expenses down to, to keep the basics (housing, utilities, food etc) and use that number to calculate your emergency fund. If you do that, you need to be committed to dropping your expenses down in the event of such an emergency.
Where do I keep my emergency fund?
This question is getting a lot of attention lately (in 2020) because we are in a low interest rate regime. Lots of folks have a lot of heartburn keeping a pile of money as cash in a regular savings account because of the low interest rates. The argument is that they can easily earn way better returns putting it in other investments. There are some strong opinions on this so I will simply share mine but ultimately default to what I said earlier – do whatever allows you to sleep comfortably in the night. My recommendation and opinion is that emergency funds should never be put in any risky investments like stocks or even bonds. Keep it simple and keep it in an FDIC insured high yield savings account. Have a separate bank account for this and dont keep it in your regular checking account – one, u dont want to keep it easily accessible that you spend it for anything other than an emergency, and two, allow yourself to earn some interest. High yield savings interest rates are also plummeting as i write this (Nov 2020) and are hovering around 0.5%. But I go back to my earlier reasoning – the purpose of the emergency fund is not to earn you fantastic returns. It’s to protect you against emergencies and is a financial cushion.
Now, some folks could argue – I have an HSA (Health Savings Account) that I have built up and can serve as a cushion for major health emergencies. I agree – an HSA is definitely something you can tap into for health emergencies. If you are one of those who has been diligent about saving in an HSA, you certainly can tap that and can make an argument to lighten your emergency fund.
Other folks argue – I have credit cards, lines of credit I can tap on my assets like a 401K, my personal property etc. All of those are valid but my humble opinion is that tapping those is not moving to a position of financial strength. If you are not careful, it can quickly move you to financial distress with debt.
I will leave you with this final thought – personal finance is personal. So it’s whatever works for you. Ultimately you get to decide what makes you feel financially resilient and don’t let anyone tell you otherwise! I wish you luck on your financial wellbeing journey!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
