What is an emergency fund? It is an amount of money set aside for emergencies. Such emergencies could be a job loss, a sudden illness or an unexpected expense. Most experts recommend to put aside three to six months of living expenses in a highly liquid account such a savings or checking account. Emergency funds are supposed to save you from having to use a credit card or selling some of your investment assets.
My case: My living expenses are $2,000 per month. If I put aside six months of living expenses, that would be $12,000. That is $12,000 earning less than 1% per year at the local bank (about $100). If I invest that money and my average return is 8% ($960), my opportunity cost is $860. Over a period of many years, this could be a lot of money.
Your debt is your emergency: From what I understand, one of the reasons why you should have an emergency fund, is to save you from using your credit card. In other words, if you have credit card debt, you are already in emergency status. The credit card is your emergency. It makes no sense to have money in a savings account, earning 1% (taxable) while you are paying 18% – 25% in credit card debt. Your first financial priority (after food and shelter) is to pay down this debt as fast as possible. If you have an emergency and you have to use your credit card, you will not be worse off.
Opportunity cost of emergency funds: Another reason why we are encouraged to keep an emergency fund is so that we won’t have to take money out from our investment account to cover the emergency. The market goes up and down, but it mostly goes up. That’s why people invest in the market. Chances are that if you have to sell some of your assets, you will sell at a gain, not at a loss. Even if the market is down, for that particular year, chances are that over a period of several years you will still be selling at a gain. So if you have an emergency, take it out of your investment account. At least your money will have been growing until you need it.
Alternatives to an emergency fund: Believe it or not, your credit card is a wonderful alternative to an emergency fund. Usually emergencies are short term. Well, if you pay for your emergency with your credit card, you have 30 days of interest free money. Within 30 days you should be able to find a better way to finance your emergency.
Another alternative is your line of credit. Keep your money in your investment account, earning about 8% per year and borrow from the bank at a lower interest rate. If you have equity in your house, you can get a line of credit at an attractive rate.
True emergencies don’t happen too often: There are recurring expenses for which you have to plan, such as changing the hot water tank every 10 years, changing the roof every 15 years. These are not emergencies. These should be pre-planned expenses. Deciding to go on a trip to Europe is not an emergency. Make sure you have a budget for infrequent but recurring expenses.
Don’t confuse emergency fund with a reserve fund. I am self employed. Some months I earn more than others. However, my expenses are always the same, so I keep a reserve fund of about $5,000. If my earnings fall short one month, I have enough reserves until the next month. Fortunately, I continue earning a bit more than what I need, so I continue transferring money from my reserve fund to my investment fund.
Do you have an emergency fund? a reserve fund? How do you deal with emergencies? Share your situation with us.
Update, March 4th, 2017. I had an emergency. I was caught without cash at the time that many expenses came about.
I had two choices:
- To sell stocks at a significant gain (people who promote emergency funds always talk about selling at a loss)
- To borrow money from my line of credit at 5%
I decided to borrow money at 5%. I get to pay back that money at my own pace and I still own stocks which have continued going up.
By putting aside a significant amount of money for an emergency fund, you are giving up all the potential gains you could have by having invested.