When you get pulled over by the police for speeding, they often ask: “Where’s the fire?”
And, when anyone tells me that they have 3 to 12 months living expenses sitting in a CD, I have to ask: “where’s the emergency?”
The assumption is that you will have unexpected expenses at some time in your financial life, and you will have to come up with a way to fund them without having to sell the kids or the dog … but, definitely not your boat!
So, the questions are: Do you need an emergency fund? If so, how much should it hold?
Today Forward presents an interesting way to look at how much to hold in your Emergency Fund:
According to the author:
If you have a full year’s worth of expenses set aside, only once every 33 years would an emergency come up that would wipe out these reserves.
Basically, you look at the chart to see how often you would tap out the fund according to how large the fund is (i.e. how many months of expenses do you have set aside as an ’emergency fund’?):
- 0 months = 100%, guaranteed to have problems
- 1 month = 70% chance (or every 17 months)
- 2 months = 49% chance (or every 2 years)
- 3 months = 31% chance (or every 3 years)
- 6 months = 10% chance (or every 10 years)
- 1 year = 3% chance (or every 33 years)
But, these are hypothetical numbers; what is the real-world chance of an emergency cropping up?
Well, the Pew Research Center set out to find out the answer to that exact question …
… and, it was 34%
Only one in three of the 2,000 families surveyed had a ‘financial emergency’ in the past year.
Combining that with the graph above, and it would seem that you would need about 3 months living expenses set aside.
However, I think it’s also important to answer one more question: how much will the average ’emergency’ cost?
Well, the Consumer Federation of America found the figure to be surprisingly low:
Households … typically report unexpected expenditures annually of only $2,000.
What are these unexpected (or ’emergency’) expenditures?
The Pew Research study found they typically fell into the following major categories (which add up to more than 34% because many families reported more than one category as having occurred in the same year):
Given that the chance of an ’emergency’ is so low (34% in any one year), and the reality is that most are affordable (~$2,000 in any one year), why carry an emergency fund at all?
Let’s take a closer look …
Let’s say that you earn $50,000 and pay 25% tax. Since you keep an emergency fund, let’s also assume that you save 20% of your take-home. That means that a 3 months living expenses ’emergency fund’ for you is around $7,500.
Since you’re going to need to keep it in a CD (earning just 1%) instead of investing it (8%+), you are giving up at least 7% interest (or, $525 in Year 1) compounded.
On the other hand, you have a 34% chance of having an ’emergency’, which will then cost you $2,000. Where will that money come from? Well your break-even point on that expense, if you had to borrow it, would be 26%.
So, borrow it on your credit card for all I care!
[AJC: Actually, I do care … the key is to have a plan to pay it off within 12 months; if you do, then a 0% card set aside for exactly that purpose would be ideal. Borrowing against your home via a HELOC would be OK, too, as would borrowing against your 401k. Sure you wouldn’t like to do any of these things, but you are dealing with the unexpected so a little short-term discomfort is probably OK]
Now, the reality is that if you were merely going to stick the $7,500 in an index fund, and earn an extra $500 or so, then I would say just go for the emergency fund … for your peace of mind.
But, why have it lying around earning next to nothing, when it could be the seed capital for your new business or the deposit on your first piece of investment real-estate?
Oh, and if you’re worried about the possibility of losing your job, well, don’t (unless you have GOOD reason to) …
… I’m not sure how different these numbers are in the USA, but if you live in the UK (according to MetLife) you have only a 6% chance of losing your job in any one year. And, when you do, you have a 30% chance of getting a job within the next 3 months, or close to 100% chance in the next 9 months.
Rather than putting your retirement at risk by setting aside too much money for an event that has only a small chance of occurring, realize that:
1. Your money is always better off working for you, and
2. While you are able to work, you can always borrow (and pay back) enough to recover from any financial catastrophe that the typical emergency fund is large enough to cover.
That’s why, at least in my mind, the best defense is always a good offense 🙂
Hey Adrian, I’m a long time reader and appreciate all of your financial advice over the years. I’d like to hear what you think about my reason to keep an emergency fund though.
I keep a 6 month emergency fund in 5 year Ally CD’s (high interest with only 2 month withdrawal penalty). I’m a 26 single male renter (no HELOC available), and I work in the financial industry. I invest almost everything outside of my emergency fund aside from a few upcoming big purchases (new laptop, vacation, etc). My logic for keeping the emergency fund is that the most likely time I will get laid off is when there is a large market crash, and the value of my invested assets will be much lower at the exact time I need the money. Also, if the market is really bad I mad need a full 6 months (maybe more?) to find a job in my industry.
Your thoughts would be appreciated as always!
I’m always intrigued about the idea of an emergency fund. On one hand having money in the bank makes you feel good. On the other hand money in the bank loses value do to non use and inflation. I like the idea of building money in the bank to an amount that you can use it to make money like buying an asset. Then you start building all over again. I do leave a little money in the bank for anything that comes up just in case. I’m all about using money to make money for me!
@ Mark – The best thing you can do, if you feel that a job loss is likely, is insure your income … if you do lose your job in a crash, it’s unlikely that 6 months cash will be enough to tide you over.
@ Michael – For a $2k ‘budget’ that would work; if, like Mark, you have a higher risk profile, then that wouldn’t work because ‘Murphy’s Law’ would put all your emergencies on the day after you cash out to make your first investment 😉
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First time visitor – I’m coming over from The Money Principle – and gosh, now I’m embarrassed to admit that I have a 5-digit emergency fund. I’ve always been the type of person who just feels better knowing I’ve got a liquid assets “just in case.” But lately, I’ve been having a LOT of thoughts about reallocating most if it. The fact is, my husband and I have had this massive emergency fund for the past seven years, and we’ve only dipped into it once – and that was to pay down a high-interest debt, which made a lot of sense. Now that we’re debt free (other than our mortgage), I just feel like this “emergency fund” is a weight, not the cushion it should be. You’ve made a regular reader out of me!
@ Elizabeth – By paying down high interest debt, you were making one of the best possible investments because a dollar saved (in interest) is exactly the same as a dollar earned (in investment returns) … a great use for those otherwise-latent ’emergency fund’ dollars!
I think one thing that may lost in all the surveys conducted on emergencies may overlook how well people manage their budgets. Some people may be going over budget regularly, or not even living on a budget, but instead dipping into savings, but when asked about emergency funds, don’t report it. Essentially, I have a personal savings account I restock periodically that helps us handle financial bumps in the road, and thus avoid selling the kids.
I keep a separate account to manage emergencies with our rental properties. It is much bigger, and it targeted to handle things like vacancies, unforeseeable repairs, and other things. When it grows above my threshold, then extra rent goes towards paying off the next rental property. It is also the account where rent is deposited, so I instantly know if we are making or losing money in real estate.
@ Greg – I like Door # 2 (“I keep a separate account to manage emergencies with our rental properties …”)
When I was 23, making $28,000 a year with $40,000 in student loans and credit cards and no savings….
a sudden car repair of $300 was a HUGE EMERGENCY. So i would have reported that.
Ten years later with no debt, a six figure income, and $20,000 in my emergency fund, $300 is nothing. My wife’s car had a $1500 repair bill a couple of months ago and the worst thing about it was the inconvenience of being a one-car household for two days. That repair was 5x “worse” financially, but in reality it was no biggie because I have a large emergency fund.
There are other benefits to having a large emergency fund, primarily marital 😀
“There are other benefits to having a large emergency fund, primarily marital”
@ Wizardpc – Too true. BUT, it comes at a price. In your case, assuming the $1500 was the only major extraordinary expense that year, the car repair cost you DOUBLE the normal price: $1,500 for the repair, PLUS $1,500 for the loss of earnings (assuming an 8% return if the $20k was invested in Index Funds).
$20,000 in an investment fund that is relatively easy to liquidate is generally much better than $20,000 in a bank account that is earning almost nothing. In the event of an emergency, you pay with a credit card and then you have 30 days to move the cash to your checking account and paying off the credit card. It shouldn’t take more than a few days to move the necessary amount.
Emergencies may never come, or they may be relatively small, or they may take many many years to occur. In the meantime, your emergency fund is earning so little that it is losing value as inflation eats away at its purchasing power. I have pretty quick access to several thousand dollars that are in a mutual fund that has gained around $350 over the past six months. It would’ve gained less than $20 sitting in a savings account during that time.
@ Milton – I like the sentiment, but investment funds shouldn’t be regarded as liquid. You could be forced to sell into a market correction … or, even, crash!
5% corrections occur 3 times per year, 10% corrections once per year, and 20% declines occur once every 3.5 years.
Any of these drops dwarf your $350 6-month gain [i.e. 5% of $20k is $1,0000].