Why You Should Have An Emergency Fund and How Big It Should Be - Life Hacker
Each Monday we’re tackling one of your pressing personal finance questions by asking a handful of money experts for their advice. If you have a general question or money concern, or just want to talk about something PeFi-related, leave it in the comments or email me at [email protected].
This week’s question comes from Vince B:
Is it important to maintain an emergency fund once you’re relatively financially secure? I.e. good credit, decent sized index investments, etc. Seems a waste to keep several thousand lying around when I could just put it on a card or margin loan.
(Disclaimer before the advice part: This is what individual experts have to say generally about an issue that affects each person differently—if you want personalized advice you should see a financial planner.)
You Need an Emergency Fund
Vince, Vince, Vince. The short answer is yes, ideally you’d still have an emergency fund even if you are fairly comfortable, financially. Because don’t you want to stay that way, even through life’s ups and downs?
“Emergency funds are for unplanned-for expenses and unforeseen circumstances—in other words, life,” says Scott Cole, an Alabama-based Certified Financial Planner. “Life does not stop because one is financially secure.”
But, ok, it’s easy to say that by invoking some amorphous emergency situation. Let’s break down all the shapes it could take.
It’s true that if you had one of the classic emergencies laid out in personal finance magazines—say, your car needed repairs or you had a medical emergency—you could always put it on a credit card and pay it off each month, paying back more in interest. But let’s say that a medical emergency turned into a full-on crisis that took you out of the workforce, or you lost your job altogether. If you get seriously sick, your credit limit is probably not high enough to use indefinitely. And if you’re laid off, it’s not guaranteed you’ll find a job in a reasonable amount of time. Then you’re just burrowing yourself deeper and deeper.
“Good credit is nice; decent-sized index investments are nice, too. But neither of them are for emergencies,” says Mitchell Hockenbury, a Certified Financial Planner.“‘Good credit’ simply gives you the opportunity to take out a loan. You still need to pay off the charges.”
These are the worst-case scenarios, and exactly what the emergency fund is built to assuage. No one thinks they need an emergency fund when all is going well. But think about it: How stable is your job, really? And what about family members who may need help? “An emergency fund is not an investment. It should be thought of as an insurance policy that you are self-funding,” says Danielle Schultz, an Illinois-based Certified Financial Planner.
How big that fund is, well, that depends on your circumstances.
You’re counting “critical” expenses—not all of the extras that make up our day-to-day. For example, do you have an expensive mortgage or rent payment you wouldn’t be able to get out of? Do you have student loan payments? Do you need to be able to drive to get to your job?
“A guy with only a few thousand dollars in an emergency fund almost certainly does not have enough set aside to cover expenses should he get fired and take eight months to find a new job...or have to decamp from his apartment because of a fire,” says Schultz. “And if any of these things happened during a market plunge, he could find himself losing significant money on investments liquidated by necessity.”
That said, Vince, you may not need to stockpile cash depending on what your investments look like. “One key factor is if there a sizable investment pool upon which they could draw upon without tax penalty if a significant emergency should arise,” says Mike Kastler, a financial advisor. “That may reduce the amount needed in an emergency fund.”
If you have a well-diversified portfolio (and what that looks like depends on your personal situation) and are ok with the risk, then some of your assets probably can stand in for an emergency fund. “Doing this is perfectly fine if your emergency fund makes up less than 20 percent of your taxable investments,” says Byrke Sestok, a Certified Financial Planner. “Above 20% you are probably taking too much risk.” You don’t need to have a pile of cash sitting in a savings account earning 0.01 percent interest or in a heap under your mattress.
But again, investing—or “maximizing”—your money comes with its own risks. Risks that you likely can’t afford if you’re in the midst of a financial crisis.
“I get we all want to maximize our cash sitting around,” says Hockenbury. “I’d just caution you as you gain wealth, very few people will lament earning little on $10,000 or so when it provides a safety margin. Never forget there is risk to all assets in one form or another.”
Peace of Mind
For people just starting out or who’ve had a few setbacks themselves, you can take it slow. As Schultz said, it can take years to get your emergency fund to a level that would guarantee you stability. And just because you don’t have the exact number that financial planners have determined is the “right” amount doesn’t make you a financial failure. As Cole says, life happens. You gotta be flexible.
But if you want something to aim for, Dylan Ross, a Certified Financial Planner and coach, suggests a 1-3-6 emergency fund strategy:
One month’s worth of expenses is a good emergency fund if you have debt. Rather than increase the size of the emergency fund, you’re probably better off putting more money toward the debt.
A three-month emergency fund is good if your only debt is a mortgage. Again, you’re likely better off maxing out retirement accounts and then putting extra toward the mortgage than building the emergency fund even bigger.
A six-month emergency fund is good if you have no debt at all. It’s a nice-to-have, but not a need-to-have at the expense of paying off debt.
Again, these are only rough estimates. Everything depends on your personal circumstances.
And one last thing to take into consideration: It’s true that you’re building this reserve fund to help you in times of crisis, but don’t discount the peace of mind that comes with it.
“An emergency fund means they are not walking a financial edge. There is a comfort level,” says Cole. “The cost of that comfort level is in opportunity, but some opportunity costs are worth paying. I have found that clients with adequate cash reserve don’t get as stressed out about financial events as those who are not going to have to dip an investment account, perhaps at a very inopportune time to fund whatever need has arise.”
Not resorting to credit cards and loans can make a stressful situation much less so. And all of this in turn means you’re really investing for the longterm, not until you need to take your money out to pay for something else.
And that’s the true point of having a reserve fund. Vince, you say you’re fairly financially stable—don’t you want to stay that way? “Having an emergency fund, even in a very boring low-interest rate earning account, gives you the freedom to take some risks in your investment accounts,” adds Hockenbury. “In other words, because you have an emergency account, you don’t have to sell investments.”
Adds Cole: “Do people fall in love with their cash? Yes. One must avoid the temptation of having too much cash. But...I have never had anyone say, ‘I wish I didn’t have an emergency fund.’”