Your Emergency FundApr 20, 2020
Your emergency fund is foundational to any financial planning. Here I discuss what it is (and what it is not), why you need to have one, and how much should be in it.
At the Margin
An economics professor once said that if you fall asleep in class and he calls on you to just reply, "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, the next dollar of debt payment. 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 routine maintenance that should already be anticipated in your budget. Another example: you just brought home $400 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 Large 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 rational people would cut back on expenses: we'd clean our own houses and cut our own grass. We'd stop going out to eat. We'd pinch pennies out of necessity to make our cash reserves stretch.
Your Emergency Fund preserves long-Term Savings and Prevents Debt
Say the transmission goes out in your car. You have to get to work. What do you do? The work goes on your MasterCard. This is the point: emergencies will come up for sure; we just don't know when. We anticipate the fact, and save into them. The benefits are twofold:
- you will keep yourself from going into debt.
- You won't need to touch your long-term investment assets, often with disastrous tax results. If you distribute from your IRA before 59 1/2, not only are the funds distributed taxable, but there is also a 10% tax penalty on the amount distributed!
Where Do You Keep an Emergency Fund?
At CameronDowning we make a distinction between dollars saved and dollars invested. 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. 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, the risk is that you'll need to liquidate during a downturn.
Here's an example: say you have a $6,000 emergency – it is July in Miami and you need a new A/C system – and that’s the amount you’ve saved in your investment account. But the market is undergoing a correction – down 20%. What’s now on hand? Your $6000 account is now worth only $4800. 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. 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.
Get in touch!
Are you maintaining an emergency fund? Do you have a cushion in place when emergencies happen? To learn more about this and other foundational financial planning topics feel free to get in touch with us at [email protected] Also follow us on LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!
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