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My FI Journey » Investing, Reflections » All About the Emergency Fund

All About the Emergency Fund

1334532_ambulanceThe emergency fund is an incredibly boring but absolutely critical part of your financial strategy.  Basically it’s a pile of cash, just sitting there.  Waiting for something bad to happen to you so that it can jump in and save the day!  Like a superhero, but with less spandex.

Those of us seeking early financial independence or early retirement should pay particular attention to their emergency funds.  As should those of individuals who make a living through contract work or freelancing.  The more unstable your income streams, the more important it is for you to have a big fat emergency fund to act as a buffer.

How Much Should You Save in Your Emergency Fund

While the personal finance world almost universally agrees that the emergency fund is essential, there is a great deal of disagreement over just how large it should be.  Anything is better than nothing, but just how much dead capital gets to be too much?

Unfortunately, since the definition of an emergency fund includes money just sitting around doing nothing, it’s basically dead capital.  So as you are considering the appropriate size for your emergency fund, you must carefully balance how much money you may need in an emergency vs the lost investment gains due to the fact that the money isn’t well invested.

Some things to consider when establishing the size of the fund:

  • How many income streams do you have access to?
  • How stable are your income streams?
  • What are your average monthly expenses?
  • Can you fall back onto your relatives or friends for support?
  • Do you anticipate any large expenses arising in the future?
  • Are there any big ticket items, such as your car, that would have to be replaced immediately, should they break?

Basically speaking, the less income streams that you have access to and the more unstable those streams are, the larger the pile of cash that you will need.  My preferred target size is six months of expenses, or the price of a reliable used car.  Whichever is greater.

Currently, I’m shooting for one year’s worth of expenses because I work in a potentially labile industry, live by myself, and don’t feel that the economy is at a good enough point where I could easily find a job if I was laid off.

When to Tap Your Emergency Fund

Since the emergency fund is basically a giant pile of money, the urge to break that piggy bank open and go on a reckless shopping spree will be there.  But it’s important to remember, that the emergency fund is not to be touched outside of an actual emergency.

So what constitutes an emergency?  Three big events pop into my mind almost immediately.  First, if you get laid off at work.  Second, if your car, which is probably the second most important thing that you own after your house, dies.  Third, surprise medical costs.  And a bonus one for you home owners, massive unexpected home repairs, “Surprise!  We’re getting a new roof!”

So unless something like I described in the above list occurs, leave the money alone!  This means that you can’t spend your emergency fund on trips to Cancun, new furniture, or beer and hookers.  That money has to come from somewhere else.

Emergency Fund Investment Options

Now that you’ve figured out how much money you should be saving in your emergency fund and you’ve been reminded that the fund is not there to pay for your next cruise to the Bahamas, we can move on to the next section – How can you best stash your cash?

Cash (as in stuffed under the mattress)

  • Pros - Sometimes you don’t have access to your bank account.  If you recall the recent hurricane Sandy, many people were without power for one or more weeks.  Stores might be open, but their payment processing infrastructure was down, so they would only accept cash.  No cash, sorry, you were out of luck.
  • Cons - You have a pile of cash sitting at home and earning no interest.  Did I mention that it was sitting at home, basically waiting to be robbed or possibly destroyed in the event of a disaster?
  • Verdict - Keeping a small (a few hundred dollars) reserve of cash stuffed in an envelope under a mattress is probably a good idea.  I can’t see any good reason to have any more of your money saved in this fashion.

Savings / Checking Account

  • Pros - Your money is in a secure institution and earning a bit of interest.  Your money is completely liquid and can be withdrawn whenever you need it.  Pretty good setup for an emergency fund.
  • Cons - Pathetically low interest rates when compared with other investment options.
  • Verdict - This is currently where I’m keeping my emergency fund saved.

Certificates of Deposit (CD)

  • Pros - Better interest than a savings account, but not by much.
  • Cons - CDs lock your money down for a set period of time (a few months to a few years depending on which CD option you pick). You can access your money early, but there are penalties involved which can be so steep as to eat into your principal.
  • Verdict - CD ladders are an attractive emergency fund option.  An example of a CD ladder would be to purchase six CDs, each one with a six month maturity.  Each CD would be purchased on a different month so that their maturation would be staggered.  This way you’ll always have one CD’s worth of money on tap should you need it.

Dividend  Stocks

  • Pros - Finally an investment that actually grows in value at an appreciable rate.  Not only can your principal increase over time, but you get regular dividend payments as well.
  • Cons - Unfortunately the stock market can be a fickle beast.  In an economic downturn, your stock prices can collapse and your dividends may be cut.
  • Verdict - I love me some dividend paying stocks.  But not for my emergency fund.  Not only are stock prices and dividends vulnerable in an economic downturn, but such downturns are the exact times that you’re more likely to get laid off, thus compounding the pain.

Gold

  • Pros - Gold can move counter to economic sentiment.  For example, during the Great Recession as stock prices collapsed, gold increased in value.  Something that moves against bad news would be perfect for an emergency fund.
  • Cons - Gold has no fundamentals and produces nothing.  There is no reason to expect a repeat performance during the next recession.
  • Verdict - Gold prices rise or fall based largely on speculation and economic fear.  Furthermore, if gold prices decrease in an economic boom and you just happen to need your emergency fund then, you could wind up losing money on your investment.

Roth IRA (yes, the retirement account)

  • Pros - One of the interesting features of the Roth IRA (not the 401k) is that you can withdraw your principal at any time, for any reason.
  • Cons - The best savings vehicles to use inside of a Roth IRA would be stocks or similar investments.  These can be, as I stated above, more volatile than you would like for your emergency fund.
  • Verdict - As much as I generally dislike the Roth flavored retirement accounts, the idea of using one as part of an emergency fund intrigues me.  You could move money into a Roth IRA and allow it to grow tax free.  But if something should happen, you can always pull the principal out.  The downside being the volatility of the investments inside of the Roth.

Readers:  How large of an emergency fund do you consider sufficient?  How do you invest your emergency fund?  What are your rules for tapping your emergency fund?

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34 Responses to "All About the Emergency Fund"

  1. Michelle says:

    We have about 6 months of expenses in ours. We could always cut things out of our budget and stretch it further though.

    1. MFIJ says:

      If you have two incomes, then you probably don’t need as large of an emergency fund. Plus, your blog brings in insane income on top of your salaries. Despite my best effort to get the cat gainful employment, we remain a one income household. If there were two incomes, I would probably cut back to six months.

  2. As intriguing as the Roth IRA option sounds, I don’t know if that would be the preferred method as it leaves you subject to the market. Just as that contribution can grow tax free, it can also do poorly leaving you in a situation where you might lock in short-term losses just to get access to your cash, similar to your gold example.

    Personally, I prefer to keep my emergency fund in an online savings account with easy access and FDIC coverage. This money is for emergencies, therefore I don’t necessarily expect significant growth from these funds, but instead prefer the safety and availability.

    1. MFIJ says:

      I agree with you. I thought I’d list the Roth option because it’s intriguing and might be viable for someone like me who is targeting a very large emergency fund. Put maybe 20% of my emergency fund into a Roth and let it grow. But for most people with reasonably sized emergency funds, the Roth idea is probably not worth using.

  3. We have three months of expenses and six months worth of mortgage payments. The last is since we run our own business and wanted to have something that could carry us. We’re in some MMMF’s and saving accounts for that and do our investing in IRA’s.

  4. I’m aiming to have one full year of expenses, but I’m comfortable with the 6 months I have now.

    1. MFIJ says:

      A full year makes me comfortable since my employment situation is always questionable. But if I lived in a two income household, I would probably cut it down to 6 months.

    2. MFIJ says:

      Six months is a pretty good cushion, especially if you’re a two income earner household.

  5. Brian says:

    I have $5K worth of cash that is easily accessible. Outside of that everything else is invested. I don’t see the point in having my money slowly disappear due to inflation. Of course I don’t have a housing payment so that helps alot. I might have a little more in there if I did.

    1. MFIJ says:

      I can’t say if $5K is enough or not without knowing your expenses and your career stability.

      I’m always a bit worried that I might get rightsized and have problems finding a new job, so I tend to keep a lot more in my emergency fund than I probably should.

      Also, I only have one car and if it dies, I’m stuck. I will need to buy a replacement immediately or my life basically grinds to a halt. I think I’d need a bit more than $5K to buy a descent replacement vehicle.

  6. Since my wife and I have contract jobs, we have 100% job security at least through 2016. So for an emergency fund, we simply keep it at the amount that would allow us to pay all of our deductibles, so if our house and both cars were to have issues, we’d be able to pay them and continue on like nothing happened. This amount currently is: $12,000, but we usually round it up to $15,000.

    1. MFIJ says:

      That sounds solid. Do you have plans to expand your emergency fund closer to your contract expatiation?

      1. After our contracts expire, we will (or should if we keep up the same tempo) have enough money in liquid assets that it shouldn’t matter. We aim to self-insure ourselves after a certain point.

  7. I like the new theme. I think that it’s important to have some cash at home for just in case. Once I have a fully funded emergency fund, I plan on having it tiered so that there is just enough in a savings account to cover me until I could access money saved in something less liquid.

    1. MFIJ says:

      Glad that you like the new theme. I still need to tweak it some more, but I think it’s coming along nicely.

      I’m considering taking a tiered approach as I build up more money in my emergency fund.

  8. Great article.

    I think your lifestyle has a huge impact on what kind of emergency fund, if any, you really need.

    Having a family, for instance significantly raises the margin of safety, economically, you need. Owning a home is another great example of a lifestyle choice that makes it a good idea to have ample cash on hand.

    Personally, I rent, have no car and also have no dependents. With a monthly budget of ~$1,000 before minor debt service, having $3k-4k in my checking account suffices to me. Of course, having access to liquid assets like stocks helps. As does having access almost $10k in credit that I don’t currently use.

    Best wishes!

    1. MFIJ says:

      I’d agree about the lifestyle. I live in a high cost of living area, so that greatly increases how much money I need, even to cover a few months. And because I live in a place where cars are the only way to get around, I need to have enough cash on hand to buy a replacement vehicle immediately if anything happens to my current car.

      I could keep liquid assets in stocks, but I’m worried about getting hit twice with decreasing stock values and job loss if another recession rolls around.

      Although if I had a second income earner in the house, I could probably cut my emergency fund substantially, since we’d still be able to pay all the bills even if my income went to zero. Now if I could just get the cat to get a job…

  9. Martin says:

    Great review. I decided to put my emergency funds into stocks. Not all of them, I keep 2000 in a savings account, but the rest goes to dividend paying stocks. I hated low interest savings accounts provided. So if I need money quickly, I can tap to a savings account, if I need more money I go and sell some stocks. I am still building my emergency fund, so my deposits go toward the savings account first, when the 2k goal is met I redirect to a broker account. When I tap to savings and drop the balance below 2k, I redirect deposits back to savings account as long as I reinstate the balance of 2k. And I pay interest on a loan from my emergency account (a variation of “Infinite banking”).

    1. MFIJ says:

      Because my goal is to never sell my stocks, I probably keep more in cash than I should.

      I would be worried about a recession hitting and losing my job at the same time. Then my stock value drops and I’d be forced to sell at a loss in order to pay the bills.

      1. Martin says:

        I understand your concerns. I have two accounts, one for retirement where I sell only when the stock doesn’t perform or stops performing (no dividend rise, cut, etc) and the emergency one, where I am OK with selling. As far as recessions, it is the risk I am OK with. With dividend paying stocks I believe it is possible to mitigate this risk to a very minimum.
        Studies shows that dividend stocks are able to beat the market by more than 50%, over the years when your pile of cash is invested, I think you can create a nice cushion to override any recession.

  10. We keep about a year’s worth of living expenses in our cash emergency fund. It’s probably more than we need but we have rental properies so we like to be prepared for the inevitable furnace/roof/air conditiner breakdown.

    1. MFIJ says:

      If I had a rental properties, I’d probably keep a ton of money on hand. You just never know when some major purchase is going to come up. Same thing if I owned a house. Dealing with maintenance is actually one of the reasons I’m not exactly gung-ho about buying a house.

  11. Integrator says:

    I don’t hold a separate emergency fund, I use my dividend income to play that role, just because i can’t stomach having 6 months expense ties up and earning <1%. Your point about dividend cuts during recessions is an interesting one. In 2009, almost 70% of dividend champions actually raised maintained or raised their dividends. The ones that didn't were generally financials, which speaks to the importance of dividend diversification more than anything.

    1. MFIJ says:

      You’ve also got a pretty sizable dividend income already. Something like $25K, if I recall. I’ve got maybe $3K at the moment. I can pay for roughly one month’s worth of my expenses on that, so I need to keep the rest in cash.

      I have toyed with the idea of something like sizing my emergency fund based on expenses minus dividend income.

      But I still consider the cost of a replacement vehicle to be the absolute minimum amount that one should have on cash. I only have one car, and if it dies I’m basically a turtle on it’s back, as cars are the only way around where I live.

  12. Jim says:

    Putting together an Emergency fund is a goal I have this year, also a college savings plan for my daughter. This will be helpful, Thanks for the great info!

  13. As we have become debt free (minus mortgage) we have been able to shrink our emergency fund substantially. Although our mortgage is at least 7 years away from being paid off completely only keep 3 months total of our mortgage payments in an emergency fund. We’re able to do this because we save abut 50% of our after tax income.

    1. MFIJ says:

      I save 50% of my aftertax income as well. For me the emergency fund is there to buffer against job loss. If I get laid off, I don’t want to have to start liquidating my investments. And in the current economic climate, I’m not expecting that I’ll be able to find a new job super fast.

  14. Our emergency fund could cover 3-4 months of expenses and it sits in a plain old savings account. We could also draw from our Roth’s if we had to but that would certainly be a worst case scenario.

    1. MFIJ says:

      I’m at about 3 months right now, also sitting in a boring savings account.

  15. Untemplater says:

    I think it’s a good goal to have 6 months in an emergency fund. Even if you’re not making much at the moment, it’s worth it to try and make small contributions. They do make a difference and add up over time.

    1. MFIJ says:

      I’m building mine slowly over time. I could build it faster if I focused solely on stashing money, but I want to keep investing. If I wasn’t so worried about finding a new job, I would cut mine down to 6 months.

  16. Suba says:

    I have been meaning to write about this, mainly because we have our emergency fund in a few unusual places. Currently we have 10 months worth of expenses (we eventually want to get to 12, but we stopped funding this pot temporarily to put everything in down payment fund).

    I have our money in this order -
    1) 1 month expenses in cash, I know this is not the worst ROI but it is small enough the savings interest won’t be a big deal.
    2) 2 months expenses in online savings account. Currently @ 0.90%
    3) 5 months expenses in foreign currency certificate of deposit in India. The foreign currency is relative to India. It is in USD but the CD resides in India. It will take me a couple of weeks to close this CD and get the money out. Currently @ 3.5%
    4) 2 months expenses in ROTH IRA invested in dividend growth mutual fund. It has grown 7.5% annually, but I know this is the riskiest as I can lose my principal.

    1. MFIJ says:

      That’s an interesting spread. I’m curious as to your rationale for setting it up that way.

  17. [...] Madness: ignoring the humble emergency fund. Where do you keep yours? My Journey to Financial Independence presents All About the Emergency Fund [...]

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