The 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.
- 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.
- 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?