Today’s let’s talk about one of the sacred cows of the personal finance community – The Emergency Fund. Almost every personal finance guru out there will recommend you to have one and most of them would recommend you to carry some amount at least.
Before I started reading about personal finance, I had no clue about it and TBH, I have never carried any emergency fund for most of my adult life. As I read more about personal finance, an emergency fund is one of the most frequently spoken about topic. It is also a topic that had much contradictory advice around it.
Hence I wanted to revisit this topic and dig deeper into it and explore how one can arrive at the right number based on his/her personal situation. Let’s find out.
What is an emergency fund?
An emergency fund, like the name suggests, is a fund earmarked to cover any emergencies. It is supposed to protect you from having to go into debt in order to cover any emergency expenses. To that end, it serves the dual purpose of helping you to cover an unexpected expense and stay debt free.
The idea is to not let an emergency knock you down and disrupt your financial plans. It’s your insurance against Murphy! Having an emergency fund is supposed to turn an emergency into an inconvenience. Sounds exciting? Great! Let us find out how much emergency fund you actually need.
How much emergency fund do you need?
Like most things in personal finance, there is no clear cut answer to this question. As much as I hate to say it, “it depends” might be the most appropriate answer in this situation. But if you were to follow the most popular guideline out there, you’d be better off having at least 3-6 months of an emergency fund in liquid assets set aside. Some experts also recommend you to go as far as 8-10 months, which is really pushing it to the limits. I have written earlier about where to save your emergency fund so that you can make the most out of it.
If you are still confused about how to arrive at the exact number, let me give you a useful technique to arrive at this number. The way we arrived at our emergency fund is also based on this calculation. We basically looked at our budget and calculated all the expenses that were required to be paid off every single month + basic living expenses. Some of these expenses include.
- Food (Groceries only)
- Insurance Premiums
- Monthly payments (auto loans, student loans, etc)
Notice that I have excluded any discretionary spending from the list since this is truly a luxury when you are battling an emergency. Most people would serve better if they kept the above expenses also to the absolute minimum and not hit the limits.
Once you add these numbers up, simply multiply that by 3 or 6 to get your total emergency fund. If you really want to err on the side of caution, you can go ahead and add some buffer to the total. But for the most part, the above categories should help you arrive at your target number.
Check out this handy calculator if you wanted an easy way to arrive at this number – Emergency Fund Calculator: How Much Will Protect You?
Why do you need an emergency fund
Another important aspect that can influence the size of your emergency fund is the kind of emergency you are trying to cover. There can be various sorts of emergencies you can plan for and depending on what it is, you can find your numbers. However, most people save for emergencies with an intent to cover the following types.
- Job Loss
- Medical Expenses
- Unplanned Travel
- Unexpected Tax Bill (yes, it can happen if you don’t pay attention to your tax withholding)
- Home Maintenance
- Automobile Breakdown
Once you take these expenses into account, it should give you a good idea what’s the safest amount (that helps you sleep peacefully at night) you need to tuck away to be prepared in the face of an emergency. The idea is to make an educated guess and add some buffer to it.
It’s interesting to note that the basic expenses I listed earlier will help you sustain your life during an emergency. The assumption is that you will be able to replace your income with a new job by the time you run out of your emergency fund. If you are a dual income household, then you are a little better off. However, I wouldn’t use this as an excuse to not do my due diligence.
What happens if you encounter one or more emergencies at the same time. What if we don’t have enough to see through the emergency? Are you out of luck? How do you tackle a situation like this?
Ways to supplement your emergency fund
Let’s take a look at some of the alternative ways you can still cover yourself when your emergency fund isn’t sufficient enough.
1. HELOC – Home Equity Line Of Credit
A home equity line of credit, or HELOC, is a line of credit secured by your home that gives you a revolving credit line to use for large expenses or to consolidate higher-interest rate debt on other loans.
It’s important to note here that most financial planners would advise you to apply for this, even before you require it. It’s not a great idea to rush to your bank while you are already in a crisis. If you approach a bank during a job loss, they are most likely not going to look at your situation favorably and approve a line of credit. My advice would be to exercise your due diligence and apply for it well before you need one. The closing costs tend to be very modest or can even be waved off in some cases. The interest rates are also not exorbitant (currently under 5-6% percent on average) either.
However, I would caution you about one thing. When there is a financial crisis, some banks either froze or simply cut off some customers’ home equity lines of credit. So you can’t bank on them as your only source of an emergency fund.
3. Credit Cards
As readers of Grokking Money might know by this time, I am not a huge fan of credit cards. However, I do carry 1 credit card myself and don’t really use it all that often. I tend to dislike borrowing money to buy anything and use credit card only for purchases that have been budgeted for. So I rarely end up paying any interest on my credit card or pay late fees. I recognize the need for responsible credit usage and the benefits of maintaining a good credit score.
Having said that, I feel it’s perfectly acceptable to depend on your credit card(s) as your extended emergency fund. Having a credit card allows you tap into them and buy a month’s worth of additional time before you owe the bank any money back. I would caution you to not look at it as easy money since it can be tempting to bank of them instead of really building a good emergency fund. Avoid any urge to tapping into them unless it’s necessary.
3. Sell unwanted stuff
I am a huge fan of simplifying my life and getting rid of any excess I may have accumulated. If you ever run into this situation, I would highly encourage you to consider setting up a garage sale to sell some stuff you don’t need and cover the emergency expenses.
If you don’t wish to do that and want to expand your network of buyers, go ahead and put an ad on craigslist or facebook marketplace. They can really help you find buyers who might be interested to buy your stuff and you can even negotiate a good deal. I love to have options when it comes to selling my stuff and these online channels really help you squeeze the last dollar out of it.
BTW, this will also help you stay out of debt and keeping unnecessary stuff in your closet. Use this opportunity to do some cleanup.
4. Access Your Roth IRA
A Roth IRA can also work as an emergency fund. Since the contributions you make to a Roth IRA are not tax-deductible, you can withdraw them at any time without having to pay any taxes or an early withdrawal penalty. For this reason, a Roth IRA serves a dual purpose:
- Tax-Free Retirement Fund
- Emergency Fund
Note that there are few things to note before you get excited to use this option.
- Avoid risky investments
This typically means if you are using your Roth IRA as an emergency fund, your money cannot be invested in risky asset classes like pure equities. So keep this in mind while structuring your portfolio to make sure it reflects your risk appetite.
This is where I question the need to use Roth IRA as an emergency fund since sticking to a conservative portfolio means you aren’t taking advantage of tax-free growth. It can be hard to make this choice knowing that your money could have grown more. It’s a trade-off.
- Track your contributions
Since you can only withdraw money from a Roth IRA equivalent to the sum you contributed, you need to make sure you don’t lose track of how much money you put in. Any withdrawal that exceeds the contributed sum, counts towards gains and will be taxed and possibly a penalty (there are few exceptions). Also, after making a withdrawal, you may have to file the IRS’ Form 8606 with your tax return. Check out this IRS page for more information.
Given the paperwork around withdrawals and the potential impact of tapping into your retirement money, I would not tap into a Roth IRA unless it’s truly an emergency and you don’t have other options.
5. Tap Into Your Investments
This is also another option when you want to supplement your primary emergency fund. Since a taxable account is funded with after-tax money, I would watch out for any additional tax I may owe by selling assets owned in these accounts.
A taxable account typically involves money invested in an index fund or a mutual fund or some ETFs. The timing of withdrawal from a taxable account plays a key role in determining whether or not your principal is safe in the first place or you are underwater at the time of withdrawal. The worst thing that can happen is for you to withdraw money from your investments by selling the securities at a loss.
So be mindful of this volatility around your investments and realize that any losses in these investments will not be a “realized loss” until you actually sell the investments.
6. Severance Packages
This is one of those specific cases when you might be eligible for a severance package from your employer, in the event of a layoff. Also, if you have any leaves accrued with your employer (which can be encashed), they will be paid out to you when you leave the employer. This is often a lesser-known way to cover the wage loss period. A generous severance package could range from 1–3 months or even more depending on the employer or employee’s designation.
I wouldn’t discount this when I compute the sum I need to save for an emergency fund.
So what do I think about this question – Is Emergency Fund Necessary?
Those who look at emergency fund purely from a perspective of “sunk cost fallacy” will consider this money as sitting idle. They will run all sorts of math around ROI if the same money was invested in the market with certain asset allocation. This looks great on paper except when you really need the money during an emergency.
You don’t want to be in a situation like the financial crisis of 2008 and bank on the investments as your emergency fund. It would be completely missing the point.
A more balanced approach would involve using an online High Yield Savings Account and using one or more of the supplemental option I have stated above. It’s important to note that you’d never keep your primary emergency fund in the stock market.
I personally keep mine in an online savings account. I would definitely encourage you to explore this option before moving towards riskier investments.
How much emergency fund do you carry? Where do you park it? Do you think it’s necessary? Leave your thoughts in the comments. I would love to know how you are managing your emergencies.