Do you need an emergency fund?
Why? Because if you have an emergency, you can use that money instead of using your credit cards or dipping into your savings account.
The recommended amount for an emergency fund is the equivalent of 3 to 6 months of your regular monthly expenses.
For example, a person with a $40,000 salary will have an income of about $3,350.
A three month emergency fund would be about $10,000
A six month emergency fund would be about $20,000
That’s a lot of money.
The typical textbook recommendation is to put this emergency fund into a zero risk, liquid account, like a savings account. Usually these kinds of accounts earn zero interest.
Your credit card is your emergency
I just read an article from the blog NerdWallet which reported the average amount of debt carried by a typical person:
Credit Card: $15,762
Auto Loan $27,141
Student Loan $48,172
In a world where credit card interest rates fluctuate between 18% and 22%, it makes no sense to have $10,000 sitting in a bank account, earning 0% while holding a credit card debt of $15,762 at 18%-22% interest rate.
Paying down your credit card debt should be your highest financial priority. There should be no savings for retirement, no savings to buy a house, no nothing, until your credit cards are paid. Your credit card debt is your emergency.
You should also pay off other debts, such as your mortgage debt ( about 4%), auto loan (about 6% ), and student debt ( about 6% ). Why forgo reducing these debts in order to have money sitting in a checking account earning 0%? This makes no sense.
Invest your emergency fund
Let’s suppose you have paid all your debts. Would it be a good idea to have an emergency fund now?
But what if you have an emergency?
The usual examples used by experts for an emergency fund are:
- Your car breaks down, or
- You get sick.
Car repairs don’t cost $10,000. If yours do, you are driving the wrong car and you have a consumption problem. Your problem is not lack of an emergency fund.
Most people get sick for about a week, this is not an emergency. If you have a more serious illness, $10,000 will not solve your problem. Your problem is lack of proper insurance.
Emergencies should be rare events which happen every 5 years or so. If you have an emergency every year, then it is not an emergency, it is a recurring expense.
What if you have a more serious emergency?
Credit card: Get your credit card, pay for your emergency, and then pay for your credit card debt within 30 days with alternative forms of financing..
Line of credit: The interest on a line of credit (right now) is about 5%-6%. It is better to have this debt at a low interest rate than to use money in your investment account which could be earning about 8%.
Your investment account: A final alternative is to take money out of your investment account. Assuming that a real emergency happens every 5 years, your investment account had 5 years to grow at an average 8% return for 5 years. Assuming an scenario where the market drops 20% right before you need your money, you are still better off than leaving your money at a savings account earning 0%.
How do I deal with emergencies?
I don’t recall having an emergency during the past 18 years. The biggest unexpected expenses I’ve had are parking tickets.
However, I do keep a checking account with a balance which fluctuates between $5K and $10k. If it has less than $5k, I panic and find ways to increase it. If it has more than $10k, then I send more money to my investment account.
How do you deal with emergencies?
Addendum: On November 2016 I had a big emergency. See article. I need it about $10,000 to get our of a financial setback. Since I don’t have an emergency fund, I sold some of my stocks. I sold at a 2% gain over 10 months. I don’t regret not having an emergency fund. This emergency showed to me that I am following the right strategy.
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