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Why do I need an Emergency Fund?

Updated: Nov 21, 2020

“You should allocate 3 - 6 months of your expenses to an emergency fund” - but why?


No doubt the world needs some general rules of thumb, especially when it comes to finances. But understanding how these came to be and how they relate to your specific situation is important.


To try to summarize an emergency fund in one sentence, it should be a cash buffer to protect against any short-term cash flow risks. There are many risks out there, so you should determine which of these have the potential of impacting you, and the likelihood and magnitude of that risk.


On the flip side, you do not want to hold too much cash. With the current interest rates today and inflation targets, you will be losing purchasing power every year on your cash holdings. It is worth it to have some protection as I describe below, but there is an opportunity cost to be wary of in the event of too much cash.


Benefits of an Emergency Fund


I think 3 - 6 months of expenses in a cash account is a great starting point, but let’s discuss some reasons why you may want more or less in there, and what this money is actually for.


There are many names I have seen for cash accounts: emergency fund, rainy day fund, sinking fund, slush fund, etc. I think these are interchangeable?... but the point to drive home is if you have (or could have) a short term need for money, keep it in cash and do not invest it (or spend it, if possible).


Aside from the financials, I find a great benefit in an emergency fund is the emotional benefit. Knowing what the plan is if anything were to happen to you or your job, and having an understanding of how much time you have to cover yourself. This relieves pressure in accepting the very first job that comes along and gives you a bit more time on that next career step.


I have found it is very empowering to say how long you have in your emergency fund as opposed to how much you have, as everybody’s situation is different.


Considerations


So what is the point of an emergency fund and what should you be protecting? Here are some things that come to mind:

  • Unforeseen health expenses (for you or a child)

  • Short term job loss (due to disability, lay off, etc.)

  • Slow year for your business

  • Car troubles

  • House troubles

Next, ask yourself; how am I going to cover these? Your emergency fund should be the first place to go. It’s a way to “self-insure” against these risks and allows you to rely on yourself as opposed to anybody or any company to cover the expense.


Some questions to ask yourself:

  • What expenses am I protecting against?

  • How secure is my job? If I lose it, how long will my cash last and how confident am I in securing another position before cash runs out? What if one spouse loses a job - will we need to rely on this fund?

  • If I lose income from a short term disability, how long can my fund last me? How long until my long-term disability policy kicks in?

  • What are the deductibles and out of pocket maximums before insurance (car, homeowners, medical) covers the rest? Can I handle this with my emergency fund?

  • What happens if all these events happen at once? Is this a possibility?

Emergency Fund is Gone - What Now?


In my opinion, as important as having cash available in your emergency fund is how easily you can you access cash. If you deplete your emergency fund, can you cover the cash need with your cash flow and next paycheck? What other resources do you have available?


Some resources or backup options and associated risks that come to mind include:

  • Taxable brokerage account - if you have a non-retirement investment account, there are no penalties to accessing this cash, but you are risking market volatility by having this invested.

  • Roth IRA - contributions that go into here can be withdrawn tax and penalty free. Not ideal, but this can be used as a backup option. Same issues with my previous point if you are investing within the Roth IRA.

  • Debt against your home - you can pull cash from a Home Equity Line of Credit, or set one up against your home in advance to draw upon if needed. This will have costs associated with setting it up and an interest rate when you borrow, but this could be a better option than others.

  • Any other debt available? Personal loans and credit card debt are typically too high of a cost and should not be relied on as a good backup option.

A point to be made is that you shouldn’t build debt just to build an emergency fund. Debt is a backup option if you find yourself in a situation like this, but pay off your high interest rate debts before starting to build your emergency fund; especially if you can easily get back into the high interest rate debt in the case of an emergency.


Coronavirus Impact and New Considerations


Coronavirus has certainly shed a light on the importance of having cash available. With so many individuals losing jobs or being out of work at the beginning of the year, it was important to have cash available to support themselves.


There was, and continues to be, government stimulus - but what happens when the stimulus is over? Mortgages will come due, student loan payments will begin again, and I suspect 2020 taxes will be higher than usual, due to taxable retirement plan distributions and the penalty associated with the distribution that many relied on for short term cash needs.


Nobody could have foreseen the impact of Coronavirus, but it raises the question; is 3 - 6 months of expenses even enough for the average individual?


Finding that balance to be able to grow your wealth but hold cash to protect against an event like this is important. Take a look at your current situation and consider: am I comfortable with my financial position in the event of an emergency?