What is an Emergency Fund and Why Do You Need One?

Let’s talk about the good old emergency fund. After all, it’s an important part of any financial plan. Emergencies and/or unexpected situations do crop up and it’s always good to have something around for those scenarios.

If you’re not already familiar, an emergency fund is money set aside for unforeseen emergencies. These aren’t any run of the mill emergencies but things that could impact your life(financial or otherwise) in a big way. We all have our standard bills to pay but sometimes, things that we don’t expect crop up like an expensive car repair or something breaking around the home. An emergency fund can be used to cover off those unexpected bills. However, an emergency fund is mainly around for an even worse situation.

I’m talking something like an unexpected job loss or illness that prevents you from earning an income.

After all, we still have bills to pay. Unfortunately, we can’t do that with a lack of income.

That’s where the emergency fund comes into play. An emergency fund is designed to be a buffer for those times when your income is limited or nonexistent. It is a financial lifeboat designed to stop you from sinking in the case of an emergency.

This money, usually in the form of an easily accessible savings account, will allow you to keep your head above water when things look bad. After all, bad events don’t announce themselves, they just sneak up on you when you least expect them.

It’s easy to forget about financial emergencies. The reality is that they’re often pretty rare. That’s especially true when it’s been more than a decade since our last recession. The stock and job market has been good and for many the path hasn’t been fraught with disaster.

However, the economic reality is that growth doesn’t last forever. We’re 11 years into a boom period and it’s probably a good time to think about what might be on the other side.

The most common example of something bad lurking around the corner is the loss of a job. This is something almost everyone of us will have to deal with at one point in their lives.

The worst part is that it will often happen suddenly and might coincide with an economic downturn. That downturn will impact the value of other savings such as stocks AND impact your ability to quickly find a replacement job.

In essence, it’ll happen at the worst possible time. After all, if you lose a job in a good economy, you might find a new one pretty quickly. On top of that, if you have money in stocks, you can potentially sell at a good time and have some money to float you through the short period of time you’re out of work.

However, the reality in a recession might be much different.

Your stocks and 401k accounts will be falling in value making selling a bad idea in the long run. Beyond that, credit will get tight making it hard to get a loan and everyone around you will be struggling to make ends meet. On top of that, the job market will disappear and it might take you months to find something new.

The worst part is that your bills will keep coming. What do you do then?

It’s not an easy situation to face any time. However, it becomes much easier if you have an emergency fund to draw on during this rough period.

It’s easy to see such a situation as unrealistic but for many, it may be just around the corner. All it takes is a change in economic conditions and you may find yourself facing it on your own. Many have already faced it in the past and it’s not easy. For me, even imagining such a situation induces a level of anxiety. It’s easy to get complacent when we’re ten years into a great job market. However, it’s unrealistic to think that will continue forever and that all of us will be spared such an event.

That’s why the emergency fund exists. It’s designed to keep stress levels down during opportune times and help you survive during inopportune times.

How Much Should You Have in Your Emergency Fund?

An emergency fund is designed to help you through a period where your ability to garner an income is limited. It can be job loss(as discussed above) or something like an extended illness. The key question is how big should your fund be? Honestly, there are no easy answers.

For most people the answer comes down to risk tolerance and your ability to save. I would target $1,000 as a starting point.

After that, the goal should be 3 to 6 months of expenses. This total is designed to cover you through an extended period of no income. The idea is that a 3 to 6 month period without a job is pretty rare. That 3 to 6 month buffer should give you enough time to find a new job or get better in the case of an illness.

However, for some that may not be enough. For example, if you work in a small specialized industry that has boom and bust times, it might take longer to find a job and therefore you should have a larger emergency fund. In the case of illness, if you have a specific condition that may lead you to miss work for an extended period of time, you might want to account for that in your fund.

The fund should stay at a consistent number once you get it up to a level you’re comfortable with. If you spend part of the fund on certain short term expenses, it’s important to replenish it to your designated max. If you have a six month buffer in there and spend part of it on a car repair, your next few pay checks should be dedicated to getting it back up to that 6 month expense mark. It’s important to actually use the money for actual emergencies! I don’t recommend touching it for other reasons with the intent that you’ll replenish it later. You never know when that actual emergency will happen and limit your ability to replenish the fund.

At the end of the day, the emergency fund has to be in line with your risk tolerance as well. Part of the idea behind the fund is to help you sleep better at night when it comes to the unknowns of life. If you’re a person who worries about job loss every day and finding a job again, it’s possible that your fund needs to be larger than someone who thinks they can find a job easily.

It’s important to keep personal risk tolerance in mind when deciding how big your emergency fund should be. However, you also don’t want to get too crazy with it. Even if you’re a risk averse person, a year of expenses should be more than enough.

Remember, that this money will be kept in a low yielding(~2.25% right now) and safe savings account. You don’t want to keep this money in an account where it could lose a lot of value like stocks. However, you also don’t want to make this fund too big. That’s because you’ll be giving up a lot of growth that you could otherwise get in stocks by keeping it in a low yielding account.

That’s why most people are best off keeping 3 to 6 months of savings in their emergency fund. The total dollar amount that may be will vary depending on your expenses. It may be $3,000 for someone in a low cost of living area and $15,000 for someone in a high cost of living area.

Six months of expenses may sound like a lot but remember the fund need only cover the basic necessities. You may spend $3,000 per month today but that likely includes a lot of optional items. The emergency fund is designed to cover the necessities like rent, food, health and anything you might need for your job search. In the case of job loss, the idea is that you’ll cut back on expenses to only cover the basic necessities until you can find a new job.

That’s why it’s important to have a good gauge of your actual monthly spend before deciding how much to save in your emergency fund.

After you figure that out, it’s time to start saving. After, you hit $1,000 in the account, I would suggest trying your best to get to at least 3 months expenses as soon as possible. Once you’re there, you can decide if you’re comfortable at that level or if you want to save more.

Any savings beyond that which aren’t needed in the short term should be in investments like stocks or bonds.

One thing to always remember is that emergencies can come in many forms. A car repair, broken A/C or a leak in the basement may necessitate dipping into the emergency fund depending on your financial condition. However, if that happens, it’s important to top it off ASAP so that you’re always sitting on at least 3 months expenses.

Even if you don’t end up using it any time soon; the sense of security that comes with a fully funded emergency fund is something else.

Where to Keep Your Fund and Why It Makes Sense to Have One?

In my opinion, the emergency fund should ONLY be kept in a risk free savings account. You want this money in a safe, accessible space when you need it.

That means keeping it in a FDIC insured savings account. You can find banks right now that yield 2.25%-2.5% but that yield will change as interest rates fluctuate. I personally use Capital One 360 but there’s plenty of good ones out there.

Your money will be safe, never lose value and grow a tiny bit as it waits to be used. I prefer that over keeping it in a local bank which yields nothing or even a checking account which can be too easily spent.

Now, some people do say that keeping money in a savings account is a waste. It’s true that long term investments are the best way to build wealth. However, an emergency fund isn’t a wealth building tool but many will still claim it’s a waste of potential gains.

After all, you can either sell securities as emergencies come up or tap into their credit cards until their income recovers. That’s not a terrible idea when the market is good. You can sell stocks at good prices and be OK and credit is rather easy to get.

However, I believe that school of thought comes from a misunderstanding of why we need an emergency fund in the first place. It’s to cover off true emergencies and those likely won’t happen when conditions are that good.

Yes, investing in stocks is better than keeping some of your money in a savings account from a returns perspective. It’s also true that you can likely tap into low or no interest debt for short term emergencies and be OK.

However, it’s likely that both will be bad financial decisions in a true economic emergency. It’s easy to say these things when you haven’t lived through anything a real recession.

The reality is that when a true financial emergency happens, it will mean bad things. Jobs will be cut, credit will be frozen, stocks will tank quickly, housing prices will fall and the only thing that will retain value is cash. Your ability to get 0% credit cards will disappear and your ability to count on your stocks will mean selling at a poor time. Sure, you can still use your current credit cards to float short term expenses but what if they drag on? Long term credit card debt at a 13%+ rate is never good.

On top of that, the impact of dropping stock prices can hurt your financial position for the long term as well.

Let me illustrate what I mean. We are currently in a bull market. That means stocks are doing well. It’s quite easy to pile into them in search for returns. Let’s say we have $20,000 to invest and need $10,000 to cover 6 months expenses. Stocks return 7% and cash returns 2%.

If I invest all $20,000 and things continue to do well, I’m much better off than if I keep $10,000 in cash and invest $10,000. It’s easy to see why having an emergency fund doesn’t look that attractive. This is the type of scenario we’ve been in the past decade.

If nothing happens and the bull market continues for the next 10 years, I’m looking good. The emergency fund seems like a waste and I missed out on investment growth by having it.

However, that won’t always be the case and that’s why I believe the emergency fund is KEY in any long term financial plan. Let’s imagine the same scenario above.

However, this time, in the middle of the 5th year, there’s a 2008 type event. Stocks crash 50% and you lose your job. It’s a bad economy and it takes you 6 months to find a new one during which period you require $10,000 to pay your bills.

You have to sell at the worst possible time to cover your bills. Not only did your stocks just drop 50% down to 13k, you have to draw 10k out to pay your expenses.

However, if you have an emergency fund, you draw on your cash instead of selling. Your stocks fall 50% as well but you don’t have to sell and lock in those losses.

After the recession, stocks rise at 9% recovering faster than the growth seen before and continue to grow until year 15. How do the numbers look then?

You can see why the “I’ll just sell stocks if I need it” camp fails severely during a recession.

One of the reasons investors under perform the index is selling at the wrong time. Sometimes that’s a choice. However, during a recession, a lack of an emergency fund might FORCE you to do just that. You may have no choice but sell at the wrong time AFTER a 50% drop. Your portfolio never recovers in this scenario and you’d have been better off not investing at all.

On the other side, you have cash to draw on from your emergency fund. Your stocks drop, but you don’t have to sell so your portfolio recovers pretty quickly and you’re back to growth after a few years post recession. On top of that, you still have some cash left and are definitely in a better financial position than being fully in stocks.

Now, this is obviously a worst case scenario. The reality is that your emergency fund will almost never be this obvious a winner. On top of that, you still have to top off the emergency fund post recession whereas in the case of being in all stocks, you might just buy more stocks earlier at good prices and help close the gap in returns.

It is the best case scenario illustration to benefit having an emergency fund. What are the odds it happens? Not 0% but pretty low but what are the odds something akin to it happens? I don’t think they’re that low for many of us and the question is do you want to take that chance? I don’t and that’s the point of the emergency fund.

It’s there to prevent the worst case scenario and to help you sleep better at night. However, even a scenario that’s not as bad as this can be detrimental to your financial position if you have to sell stocks when you don’t want to or take on credit card debt you can’t pay off right away.

The beauty of an emergency fund is that it will protect you from having to do that. The likelihood of this exact situation playing out is very low. However, something similar to it probably will happen in your lifetime.

Many people think that an emergency fund is just a net negative when it comes to investment returns. However, that doesn’t always have to be the case. Yes, it certainly is during a bull market but that’s not where the emergency fund shines. It’s there for when times are rough and stocks and other holdings are tanking.

The emergency fund will not only potentially buffer your returns in bad times but and perhaps more importantly, it will definitely buffer your mental state all of the time.

During good times, it will provide a nice blanket against the fear of things going bad. On top of that, the emergency fund will 100% be there for you in a recession. That’s why you have it and that’s why it’s there. We’re in a bull market. Emergency funds are not cool or sexy when things are going great but that’s exactly when they should be considered. Things have a tendency to run in cycles and who knows when this cycle will turn.

I don’t mind having some cash on the side even if it means giving up some returns by not putting that money into stocks.

I know that I’ll sleep soundly if I have cash in a bank account that I can access in case something bad happens. That’s what an emergency fund is and that’s why I think everyone should have one.

I don’t know when the next recession will be, whether it’ll start tomorrow or five years from now. However, I do know that an emergency fund will make it a lot less painful than it would be otherwise.