Emergency Fund: A Guide to Financial Security
Fair warning: I am not a certified financial planner. This article contains advice based on my experiences, but I will bet that if you sat down with a CFP, they would tell you the same thing: It is critical that you keep a rainy day fund, often referred to as an emergency fund.
The Average American’s Financial Security
Every time economists conduct research on the financial health of the typical American, one statistic stands out: over half of Americans are in a financial position where any serious emergency would cause insolvency. Over half of Americans do not have the financial resources to deal with a minor emergency such as a car-accident much less losing their job or huge medical bills.
That means there is a 50/50 chance that you have no emergency fund at all.
Instead of feeling guilty, let’s discuss the advantages of an emergency fund and factors you should consider.
The Present Value of Saving Money
The greatest present benefit is a reduction in your anxiety. Anxiety is often caused by financial concerns. What is going to happen if you get a speeding ticket, or you need to repair your car, or you must buy new appliance for your house or apartment? How are you going to pay for those little things?
That is the beauty of putting aside money every time you receive a paycheck. The money in your emergency fund will save you in those sorts of situations.
You already know that you should save money in emergency fund. But have you calculated how much you should save? Probably, not. So, let’s start by explaining what an emergency fund is, what it is for, and how much you need to save.
There are two main reasons you should have an emergency fund:
Unexpected increase in costs
Unexpected decrease in your income.
We are going to explore both. But let’s start with,
1. Unexpected Costs
You may be great at planning your expenses and budgeting your money, but you will face moments where you need to cover unexpected expenses. The most common situation seems to be car accidents that require you to pay some of the damage. Or, perhaps you found a new job but failed to calculate your taxes properly. And one day you receive a letter from the government stating that you owe the IRS money.
It is important that you have money to cover those costs. The alternative is paying a lot of interest on borrowed funds.
I recommend that you keep (at least) a few thousand dollars in a savings account for your emergency fund.
2. Unexpected Decrease in Income
As the relationships between employees as corporations become less focused on community and partnership, job security is becoming an increasing problem. It is not uncommon for someone to lose their employment after their employer decides to restructure or cut costs by laying off staff. This happens most frequently to people in their twenties and thirties, which (unfortunately) is when a person’s financial situation is most precarious. When I was young, I thought job loss was some tragic, rare circumstance that happens to older people: I was totally wrong.
How Much Should You Save?
There is some debate over how much money you need to save (which usually corresponds to how many months you should be able to sustain yourself off an emergency fund alone). I am going to ask you to look in the mirror and ask yourself how well you manage your money.
Some experts say you should save enough money to cover three to six months’ worth of necessities:
The cost of your rent
The cost of food
The cost of utilities
But there are also experts that argue that people do not tend to change their lifestyle overnight, so you should save enough money to cover your current expenses for three to six months.
I am not going to try to tell you what exactly constitutes an emergency because people’s lives are so unique. People tend to define emergencies very differently.
Think of it this way: imagine an unexpected event in your life that will force you to spend money that is not supplied by your income.
Consider your employment situation.
People with tech experience are in high demand.
Take your job and the industry in which you are employed into consideration. If you work in an industry where there are lots of jobs, and few viable hires (a labor market favoring labor) then you may only need a few months (or weeks) to find a job. But if you are an expert in a very specialized role, it can take a very long time to find a job due to the limited number of employment options. If that is you, I hate to say it, but you will need to save much more.
How much money should you put in your emergency fund? If you have zero savings right now, and I tell you that the answer is a massive amount of cash, you might decide that making an emergency fund is not worth the bother. Why would I get started?
Instead, think of it this way: the key to creating financial security is living on less than your income. Set a budget for yourself that is around 60-70% of your after taxes take home income.
As a rule of thumb: your emergency fund should be large enough that you are not afraid of losing your job.
This independence important because it also allows you to live in a much healthier way. If you are not terrified of losing your job, you give yourself the freedom to quit if you feel that your employment situation is unjust. Basically, you do not want to be a slave to anyone or anything, including your employer.
What is more Important than an emergency fund:
Before we get started, I think I should mention that the first thing you do with your spare money is put it in a retirement plan where your employer matches the money you invest in your 401(k). The reason this comes first (even before an emergency fund) is that you are receiving free money from your employer. Free money is good.
After you have exhausted what your employer is willing to invest for you, place the remaining savings in a rainy-day account. You can start small. Some people will save as little as a penny for every dollar they make. Do whatever you can to start building up that reserve so that when you run into an emergency, you can draw money from your savings rather than borrowing money at interest.
A common question that people ask is, what should I do with the money in my emergency fund?
There are a lot of options, and I cannot tell you precisely which ones are best for you. But I can offer you some general guidance and some variables that you want to take into consideration.
How Should You Invest Your Emergency Fund?
1. Constant or dynamic saving?
First: If you do not invest the cash in your emergency fund (and leave it sitting either in cash or in a savings account with minuscule interest) and you do not to use your emergency fund for several years you will lose (a) an opportunity to grow that money and (b) the value of your initial investment due to inflation.
2. Locked Accounts
You should also consider whether you are comfortable with having your money locked in. You can often earn a better return if you lock in the money for a set period: such as a year or two. However, you cannot withdrawal that money for that interval of time. For example: If you were to lock away the money for two years but run into an emergency in your first year you could not access your investment (or you would pay very hefty fees that could wipe out a large portion of your emergency fund).
This is a liquidity problem. High liquidity is a good thing, but just like everything else you pay for it in one way or another. As an arm chair economist, I can assure you that there is no such thing as a free lunch. It is probably not a good idea to lock in your money so that you can access your funds in case of emergency.
You really, really need to consider how much risk you are willing to take. The higher the risk associated with your investment, the greater the pay off. Generally, the expected value of a payoff is consistent between your investment options. Note: the following indented section gets a bit technical. You can skip it if you want.
Here is how you calculate expected value:
(probability of success)x(pay off if successful – cost if successful) + (probability of failure)x(pay off if you fail – cost if you fail)
*Probability of success + probability of failure = 1.
Generally, the expected value between various investment options equalizes. This is because the probability of success decreases/probability of failure increases as risk (and potential payoff) increases. This is particularly true in large markets with lots of investors. If one investment option is truly better, investors will move to that option until the pay offs equalize.
Riskiness is measured by information (or rather, lack of information). Why? If you know what would happen to the investment, you could pull out in time and so not lose any of your investment. By becoming more knowledgeable about your investments, you can increase your probability of success, and thus increase the expected value of your investment.
*You should note that expected value measures the average amount of information held by investors in the market. If you hold more information than average, you can increase your expected value (by changing the makeup of your probabilities).
Takeaway: Only choose risky investments if you have more information (expertise in that investment) than other investors. Or, if you have a very diverse investment portfolio with risks that are inversely related (so that when one investment fails, another gains). However, that latter option is really a type of none risky investment.
The whole point of an emergency fund is that you have guaranteed money for you in case you run into an emergency. That is why it is usually not a good idea to make a super risky investment. You may get into a car accident or get fired only to discover that you have also lost half of your emergency fund.
It is very difficult to find an investment option that has a very strong return and the liquidity and security that you want for your emergency fund.
The easiest place to keep your emergency fund is in a savings account.
It is not that important that you make a strong return. A slow, steady return that counters inflation is better than nothing.
When you have a stable job, you have access to credit (borrowed money). If you are responsible with your credit (keep your credit score high), you might have access to that credit in a situation in which you no longer have income. But I would not rely on this safety net.
I want to challenge you to look at your expenses today and think about how much money you need to save in an emergency fund to cover both types of emergencies we outlined.
Make saving money a lifelong habit. Why? Every study shows that save are wealthier than their high spending counter parts. And even better, strong economies are built on a culture that encourages saving (which the United States is not). High levels of saving on a national level provides the resources for business to make investments that cause the economy to grow.