I was reading some blog posts recently arguing you don't really need an emergency fund and I realized I have never written a post about emergency funds. So this post will serve not only as a “back to basics” post about emergency funds, but also a sophisticated argument that they probably still have a place for most people, but that you don't have to be dogmatic about it.
Dave Ramsey Dogma
Let's start with the dogma. Perhaps the best way to summarize it is to use Dave Ramsey's well-known emergency fund recommendation. Dave recommends you save up a $1000 “baby emergency fund” before doing anything else financially. This can be used for a minor medical bill, a minor car repair, a broken appliance etc rather than forcing you to take on more debt. Then Dave recommends you pay off all your non-mortgage debt. Then he recommends you save up a “real emergency fund” of 3-6 months of expenses. THEN (and only then) you can start saving for retirement.
Do some people need that much structure? Yup, they sure do. But those are also people who actually use credit cards for credit, so it may not necessarily apply to you. Be aware that nobody recommends you save up 3-6 months of income, it's EXPENSES, and only required expenses at that.
The Purpose of an Emergency Fund
In my view, an emergency fund has several purposes.
- Actually save
- Avoid selling investments in a down market
- Avoid liquidating illiquid investments
- Avoid going into debt for an expense
- Allow you to take more risk elsewhere in your life
If you have a net worth of zero or worse, saving up an emergency fund, even a $1000 one, is a useful exercise. You get to learn to not spend everything you make and to actually have savings you don't touch except for the reason why you saved it. I think that develops some useful financial muscles.
One of the tenets of successful investing is to avoid buying high and selling low. If you have a major expense come up in your life, it is possible it will coincide with a down market, forcing you to sell low. If you have an emergency fund to tap, you don't have to sell that investment low to get cash. If you don't think that ever happens, I would recommend a book called The Great Depression- A Diary, which is a real-time diary written by an attorney throughout the 1930s. One of the recurring themes of the book is people selling stuff for far less than it was worth and how much the attorney wished he had some cash to buy up some very appealing stock and real estate deals.
Some investments aren't very liquid. Perhaps they can be made liquid, but only at significant loss. Having emergency cash allows you to avoid having to fire-sale illiquid investments, assuming they can be sold at all.
Another purpose of an emergency fund, at least for me, is to avoid having to borrow money in the event of an emergency.
Finally, the psychological backstop of an emergency fund allows for more risk to be taken elsewhere in your financial life. For example, you can raise all your insurance deductibles and save on premiums. You can worry less about a bear market because at a minimum you know you can live for 3-6 months without touching your investments. You can take more risk with your career knowing you've got “Walking Money” in your pocket.
Why Borrowing and Future Earnings Aren't an Emergency Fund
The Early Retirement Now blog is not afraid to get up on a soapbox and preach against a traditional emergency fund, and to be fair, I agree with much of what ERN says. Basically, his emergency fund/plan is:
- The float on his credit cards
- His next paycheck
- A HELOC
- Tapping his investments
The problem with this plan is that it doesn't line up well with what I view as the purposes of an emergency fund. For example, if the purpose of your emergency fund is to avoid selling investments in a down market, then your investments don't make for a very good emergency fund. Again, if the purpose of an emergency fund is to avoid going into debt, then going into debt isn't a very good emergency fund. The other problem with this plan is that when everything goes bad in life, it tends to go bad all at once. For example, imagine getting a cancer diagnosis. Right when you need extra cash for medical bills you also lose your income. Sure, you've got disability insurance, but that doesn't kick in for three months. What do you use for those three months? The emergency fund. In addition, many times when people lose their income they also lose their ability to borrow. Who wants to lend to a guy without any income? Not very many people unless you can hide that fact from them.
And future earnings? One of the main emergencies people have is losing future earnings. ERN basically doesn't have an emergency fund. Luckily, he's wealthy. And when you're wealthy, well, you have much less need for an emergency fund. For example, I'm quite confident my family could live just fine for 20 years off what we have saved right now given our relatively low fixed expenses. Do I REALLY need an emergency fund? Probably not. Does a typical retiree? Not really. His entire nest egg is an emergency fund.
An Emergency Fund is Like Insurance
In many ways, an emergency fund is a lot like insurance. It allows you to take risks that you otherwise could not take. But also like term life and disability insurance, if you have strong financial muscles and are a good saver and investor, eventually you grow out of it and can “self-insure” against the risks it was meant to cover. Since an emergency fund is insurance, the return OF your principle matters a lot more than the return ON your principle. Like buying term life insurance, it isn't about the return on your money. You're supposed to lose money on insurance because it costs something.
How to Invest an Emergency Fund
A frequently asked question is how to invest your emergency fund. There is no right answer, but again, go back to the purposes of an emergency fund for YOU. If one of the purposes for your fund is to avoid selling risky investments when they're down, then you can't invest the emergency fund in risky investments. The very best emergency fund is probably stored water, canned food, plenty of gasoline, some camping gear, an AK-47, and plenty of bullets. After that, a big stack of cash kept in a safe or hidden location in your home is probably best. If you're really extreme, you might even want that cash in multiple different currencies. I certainly don't advocate your entire emergency fund be kept in your house, but remember that one of the emergencies you are insuring against with an emergency fund is a bank closure. Now that's a lot less likely with the FDIC than it was in the 30s, but being able to get at least some cash when banks are closed and ATMs aren't working is useful.
Our emergency fund, until recently, was invested in the Ally Bank high-yield savings account paying 1%, but as rates rose we recently moved it to the Vanguard Tax-Exempt MMF for a higher after-tax rate and a similar level of safety and convenience. A long time ago, it was in the Vanguard Prime MMF. It seems like forever ago, but prior to 2008, we were earning 5.25% in that fund.
How Health Savings Accounts Tie-In
A lot of people wonder whether their HSA should be part of their emergency fund. HSAs are great. I fully fund mine. But the problem with an HSA as part of your emergency fund is that it can really only be used for one type of emergency unless you want to pay taxes and penalties on the withdrawal. I suppose if you've been doing the “saving receipts” strategy (paying for health care with taxable dollars, while saving receipts for future tax and penalty free HSA withdrawals) then at least you can access some of it tax and penalty free, but if you're trying to keep money in your HSA, you probably have it invested aggressively, defeating one purpose of an emergency fund. Bottom line, an HSA isn't an emergency fund.
The Problems With an Emergency Fund
So with all these great benefits of an emergency fund, why is anyone against them? It basically boils down to opportunity cost. Very safe investments don't pay much. Guns and ammo might keep up with inflation, but cash in a safe doesn't. Your checking account probably doesn't pay interest at all. Even if you're wise, your savings account is probably only paying 1%, less than inflation. Meanwhile, that money could have been invested in real estate or equities and be earning 6, 8, 10% or more! There's a very real cost there.
There is another opportunity cost too. Every dollar not placed into a tax-advantaged account is tax-advantaged space lost forever. Especially if you're not much of a saver, maybe it takes you two years to save up 6 months of expenses of an emergency fund. You just missed out on all kinds of tax-deferred, tax-free, or maybe even triple-tax-free space like an HSA.
My Own Emergency Fund History
It is a terrible truth that the poorer you are, the more you need an emergency fund, the harder it is to accumulate, and the higher its opportunity cost. By the time you're rich and it is easy to acquire it and the opportunity cost is no big deal, you don't even really need it.
Back when I was poor (or perhaps better stated, not rich yet) we tried to acquire an emergency fund. We usually had a few thousand sitting around somewhere. But every January, we raided it to max out our Roth IRAs. I think I tried to justify it by pointing out that we could always withdraw Roth IRA contributions tax and penalty free. But I wasn't leaving that Roth money in a safe investment. It was mostly in equities. So that kind of defeated at least one purpose of an emergency fund. It was just too painful for me to pay that opportunity cost. So our true emergency fund throughout residency and at least the first 5 years of attendinghood was less than 3 months of expenses. But throughout that period we were becoming wealthier and had more and more resources each year to tap in the event of an emergency. So the risk we were actually running was rapidly going down. By the time we were 7 years out of residency and actually had a “6 months of expenses” emergency fund, there were a million dollars worth of resources somewhere else in our life and our need for an emergency fund was dramatically lower.safe harbor), and 2017 first quarterly estimated federal taxes. Then, sixty days later, the estimated taxes for the second quarter are due. So our cash balance is generally highest in the Winter and lowest in the Summer. How long could we live on $335K if we had to with no other income? At least three years. Maybe twice that. Is there a serious cash drag on that money? Yes. Can I afford that cash drag now? Absolutely. Besides, it just doesn't feel right to take money due to the IRS in 3 months and invest it in anything but the safest investments. Do I really need to hold $60K in cash as an emergency fund? Probably not, but it makes me sleep better given our aggressive retirement, college savings, and HSA portfolio.
There you have it. Everything you ever wanted to know about emergency funds in general and my emergency fund in particular.
What do you think? Do you believe in the concept of an emergency fund? Why or why not? How do you invest yours? What have you had to use it for? Comment below!