An emergency fund is money that’s put aside in case of an emergency. That was easy wasn’t it? But how big should it be and where should you even keep it? Your answer is likely to be different than mine. But I realized yesterday that I don’t really know why I’m keeping 1 year’s living expenses in my emergency fund. It’s time to re-evaluate.
What is an emergency?
You probably have your own definition of an emergency based on your personal situation. If you don’t, I encourage you to define your own.
Generally speaking the main reason for dipping into your emergency fund is due to loss of income from becoming unemployed or from a medical / health condition. Other large expenses might also be reasons for using it for example, replacing a broken HVAC system in your house. However a bargain sale on clothing / shoes / electronics offering great prices is not reason to spend emergency funds, although it might be a great opportunity if you’ve budgeted for it.
Thinking about and writing this article helped me define what I consider to be an emergency. While I’ve been fortunate enough to never use any emergency funds, I’ve always ear-marked it for loss of income or for large expenses.
After considering my situation further, I’ve concluded that large ‘unexpected’ expenses aren’t really that unexpected after all. Most of them relate to the hidden costs of house ownership and should be planned for appropriately. We moved into our house in Michigan one year ago and it’s a great house, we love it!
However I know that sometime in the future, the HVAC system or water tank or kitchen appliances are going to need replacement or major repair. Rather than using my emergency fund, I should consider making a plan to save up money in my general savings account so that I can in theory even replace them before they fail and not have to make an urgent purchase in a crisis. I’m not considering a home warranty for this; I prefer to self-insure where possible.
There are other methods to pay for such replacements too, for example, interest free loans or deferred payments which I would consider using in such an event.
So going forward my emergency fund is solely for handling loss of income, and as my investment income increases, I should be able to reduce it further.
How much money should I keep in my emergency fund?
This is another personal decision as there are many factors involved. You should think of the emergency fund in terms of expenses, rather than income. And this comes back to your budget – good budgeting is critical for financial independence. After all, if you don’t have a good handle on your monthly expenses, how will you know when you’ve arrived at financial independence?
An emergency fund anywhere from 3-6 months of expenses is a common amount. But there’s no hard or fast rules. I have 12 months of expenses in mine currently but that’s going to be revised (downwards to 6) as a result of this article.
You might want to increase the amount if you work in a field that may take a long time to find replacement employment, or if other employment opportunities are limited in your area. And you could consider decreasing the amount if you have side income or a dual-income household.
Ultimately, there is no right or wrong amount and it’s most important that you’re comfortable with the amount you’ve chosen. However try to keep as little as you’re comfortable with since any surplus cash can be put to better use in investments.
Where should I keep my emergency fund?
The usual suspects are either a high interest savings account, a certificate of deposit (CD) or a combination of both. With online savings accounts you can earn 0.8 – 1% interest. I have savings accounts at American Express (0.8%) and Barclays Online (0.9%).
For CDs, Barclays offer a 5 year CD at 2.25% and Ally‘s 5 year CD is 1.6%. There are penalties for early withdrawal so you can set up a ladder of overlapping CDs or just take the penalty if you ever need to use the money. But that 2.25% yield looks pretty attractive to be honest.
If you use an online account, I’d recommend putting your emergency fund in entirely separate accounts; so that it’s not mixed in with any savings or checking accounts. Out of sight is out of mind and hiding it / making it harder to access will help you keep it intact.
I must admit that I currently have 7 months of expenses in an online Amex savings account and an additional 5 months expenses in the Vanguard Short Term Bond Fund VBIRX. Because it’s more volatile than cash, I did put a little extra in so that it’s likely to always be above my target threshold. I wouldn’t recommend a bond fund though, at least not in the current economic climate of rising interest rates.
What if I can’t afford an emergency fund right now?
If you’re deep in debt then most of your spare money should be going to pay down the debt. And if you’re living paycheck to paycheck then you might not be able to spare money to put into your emergency fund. However in both cases, you’ll still have the same problem if your income stops.
There’s no magic answer here unfortunately, but it does start with making a budget and sticking to it. And if you can spare even $10 a month to squirrel away into an emergency fund, having a budget and a plan will help build the discipline to improve your financial situation. It can be done but it won’t be easy.
What about my line of credit instead?
Using a HELOC as an emergency fund may be an option depending on your comfort level. There are risks that the credit could be frozen in the event of another major bank meltdown. If you’re comfortable with it and have done your due diligence in making that decision, then go for it.
Or my Roth IRA?
This is another common approach. You can withdrawn money from your Roth IRA with no penalty. The main disadvantage here is that you can’t put that money back in afterwards, so if you’re young might lose a lot of future income by withdrawing it.
My Dividend Income Portfolio
My portfolio could be considered more than adequate for an emergency fund and it would support for me about 3 years if I really needed it. But I must admit that I like the security of having cash ready to access. I hadn’t really considered this as an emergency fund to be honest either; but I think I will draw down my emergency cash reserves as it increases in monthly income.
A change in direction
I started this article with 1 year’s expenses in my emergency fund where my monthly expenses are $3,975.
I’ve challenged myself to budget to fund a long-term savings account to save up for future house related costs such as installing a new air conditioning system. While I include a monthly amount for house repairs in my regular monthly budget, that’s aimed at more mundane and common repairs not the big ticket items.
I’m also going to reduce my emergency fund in size to 6 months through the course of this year and seriously consider getting a CD which have fairly good rates at the moment.
I’m going to put the difference into my regular savings accounts for long-term savings although I may invest some of it. With my dividend income portfolio I simply don’t need such a large amount of cash sitting around depreciating all day, and I could always sell some stock in an emergency.