When things go sideways in life, it’s smart to have a plan… enter: the emergency fund.
When most think of an emergency fund they think cash in a savings account. This is but one avenue.
An emergency fund is a stash of cash, liquid investments, or a line of credit that can cover an unexpected, big expense.
Today we’re going to explore why you ought to have access to funds to protect you, the various options available to you, and how much you ought to have. There is a balance between running lean with a small cash reserve and having a huge cash reserve.
Many readers of this site may still be in debt – should you pause your debt payments to save for an emergency fund or stash some cash just in case? We’ll cover that too.
Let’s explore the options so you can make a better, more informed decision with your money.
Simply put, it’s a form of insurance against the unexpected. Just as you’d insure your health or your car.
It’s the financially responsible thing to do. We talk a lot about financial security here. Having a plan in place for when things go south is part of being financially secure.
A lot could go wrong and it’s impossible to plan for everything. But, it is possible to plan for quite a lot as we’ll talk about shortly.
If you do a quick search, you’ll find most places and experts recommend three to six months worth of expenses.
Depending on your financial situation, I think many could get away with a little less, if you’ve got the risk tolerance for it. We’ll explore those options at the end and why I advocate for those if you’re up for it.
Think of your dollars as little employees, working for you day in and day out. If I were to save up 6 months or more of expenses, I’d have a lot of cash sitting in a bank account making close to nothing in interest (effectively losing money thanks to inflation).
However, if I put all of my dollars to work today and something happens to me or my family in a week, then I may not be prepared.
Striking the balance is key but it takes a bit of an understanding of your expenses and spending, potential job security, and also your general tolerance for risk, amongst other factors.
When determining the amount you’re trying to save, consider how stable your career and industry are.
Before we calculate a number, let’s consider all of your options.
Below are a few of the most common ways to protect yourself against an emergency. Let’s look at the pros and cons of each medium so you can make more informed decisions with your cash.
Cash has a lot of good pros and no matter which option you choose, having some cash on hand is a good idea. I personally keep 1 month of expenses on hand, max (a more aggressive approach). This is because I utilize multiple avenues and don’t rely on cash alone.
Pros:
Cash is the first thing that comes to most people’s mind when talking about an e-fund. It’s the most liquid, or easiest to use, in case of an emergency.
To build an e-fund with cash, all you need is a paycheck and less expenses than you earn. That free cash flow can begin to build you an e-fund that quick.
Cons:
The downside is that it could take you a while to save up enough cash to get to the amount you desire. $50 a month for a year is only $600. If your expenses are $3,000 a month, you’d need $9,000 for 3 months worth. To get to that number in a year you’d need to save $750. I’d wager there’s a better use of $750 a month, especially if you’re in debt.
On top of that, if you put your extra cash into an e-fund for months and forego time in the market, you’re missing out on potential investment gains. This is the biggest downside of cash in my opinion. That and the fact that as of right now most bank savings accounts pay around 0.4% (and these are branded as the “high-yield” ones).
If you’re fortunate enough to have money already invested in the market, here’s some considerations.
Pros:
Investments are generally quite liquid. You can sell and transfer them to your bank account in less than a week in most instances. Some people have a lot invested, providing a big cushion.
Cons:
You will have to pay short-term (taxed at ordinary income level) or long-term capital gains tax on whatever you sell. You could be selling for a loss, which is not good either.
A huge downside of having to sell investments is stopping your time in the market.
If you’re lucky enough to have someone in your family to help, it can be a bit awkward to ask, but don’t let your ego get in the way.
Pros:
Usually low-interest or 0% interest loans. Typically quite liquid. Some family members may be able to help with quite a lot.
Cons:
Awkward to have to ask for some people. May come with unwanted stipulations. Has the potential to ruin relationships if something goes wrong with the transaction or payback.
Some family members may be willing to help you no matter what the cost is to them. Be sure you’re not putting them in a worse position to get out of yours.
Pros:
All you have to do is swipe your card, very liquid. If you’ve got good credit, getting a card isn’t difficult. It’s not uncommon to have access to thousands through your cards (some have multiple).
If you’re able to cover the emergency expense by your next paycheck (or a combo of savings + next paycheck), this is an ideal option because you won’t accrue interest. It buys you more time due to the lag in billing periods.
If your credit card has cash-back or travel points, you could get some benefit from your misfortune. Talk about making lemonade from lemons.
Personal loans can have much more reasonable interest rates and be available to you rather quickly as well.
Cons:
Since there’s nothing guaranteeing your line of credit, lenders charge exuberantly high interest rates for you to use their money. Carrying a balance on a credit card for an emergency is less than ideal.
These next two are more advanced techniques. They come with their own unique risks and rewards. Most know how to use a credit card, but have you considered these options if they’re available?
A HELOC is a Home Equity Line of Credit. Naturally, this only applies to readers who own a home. With this method you’re given a line of credit based on the value of your home.
Pros:
Generally speaking, you can draw quite a lot from these whenever you need it. The interest on repayment is usually quite reasonable too, making this a desirable form of e-fund for larger mishaps.
Cons:
HELOCs typically have variable interest rates, meaning your monthly payment could be inconsistent when rates are changing.
Having this much money at your disposal can be tempting for those who don’t have their impulses or finances under control. Make sure this is only reserved for emergencies.
Borrowing on margin is borrowing against your securities (like your stocks or index funds).
Pros:
You can easily apply online through your brokerage. If you have a lot invested, you may be able to borrow quite a lot in a pinch. Instead of selling investments at a 15%+ tax rate, you may be able to borrow from those same securities for 4%-8% (depending on the lender and amount lent).
Cons:
The worst case scenario is you borrow on margin, then the value of your securities falls. This means not all of the money you borrowed is secured anymore. In these instances you could face a margin call – the brokerage firm will require you to pay back the missing funds immediately. Some may even sell some of your securities without your permission.
The next most common question I get after “how much should I have” is “when should I fund my emergency fund?” It’s a good question, because it’s not that straightforward.
Now that you’ve seen the various options, the answer to this question might be a little more clear. If you’re only considering cash for your e-fund, foregoing paying down a 25% interest credit card comes at the expense of a lot of money in interest. Let’s go through the various scenarios of when you ought to fund the e-fund.
I’ll run through a few of the most common scenarios I see and give you an explanation of what I’ve done or what I’d recommend thinking about trying. As always, I’m here to provide you with both the financial, math side and also the emotional side. Taking both into consideration, you’ll make a better, more informed decision.
I’ve got a post as well about which order to pay your debt off in too, check it out here.
The trade off you’re faced with in this scenario is socking away cash or paying down an extremely high interest loan.
In my personal experience, it’s always benefited me to pay down the loan. In most cases, you’ll do this and then have the free cash flow there after to begin funding your e-fund. Worst case scenario, you pay off the card and then you must use it again when a major, unexpected expense comes.
It’s not ideal but it’s one of the strategies we spoke about above. Going this route helps you to save money on interest while getting debt free faster and freeing up your cash flow.
This is where it comes down to personal preference. Student loans and auto loans generally aren’t that high of interest. However, they can take a long time to pay off.
Should you take 1-3 years to pay these off before saving for an emergency fund? Or would it be smarter to sock away a little extra cash here and there until you’ve got 3 months of expenses covered?
In the past, I opted to pay down all of my debt first before establishing any type of cash emergency fund. With that being said, I did have access to plenty of money through my credit cards. I was fortunate that I never had to go that route, either.
I could see why someone may want to opt to save for a cash fund first. If you’re not planning to pay down your loans at an aggressive or accelerated rate, it’s not reasonable to say you’ll start an e-fund in 5-10 years!
Anecdotal personal story: Someone I know never had any credit card debt and was okay with their student loan debt. They paid off their car and began stashing all their free cash flow into their savings. Eventually they threw half of that into the market. A year later they wanted to quit their job and they were able to because they had a bunch of cash and investments to back them up and cover their expenses for up to a year – buying them time to start their business.
If You’re Out of Debt
This is a bit more straightforward. Being mostly or completely debt free, you can begin to explore the options above. Determine how much you need and go from there based on those options plus your natural risk tolerance.
Once I got out of debt, I saved up about $3,000 and then ramped up my investments and never looked back.
Now, my personal line of thought generally goes like this: Pay off all debt first -> sock a little cash away -> invest aggressively. All the while, work towards increasing your income and reducing your expenses in order to maximize that cash flow.
Hopefully after reading through these, you’re feeling better about how much you ought to have and the options available to you.
I used to dread the thought of having to save up 6-months of cash, knowing I could be putting that money to work for me through investing. I’m thankful I found these other options, as they allowed me to run my personal finances a bit more lean and take advantage of the market gains over the past few years.
As always, be educated on your decisions and find what works best for you.
Here are ways to support, stay in touch, and work together:
I look forward to speaking with you and helping guide you down this life changing path.
In health and in wealth,
Seth
