Of all the things you can do to improve your financial future, setting up an emergency fund is at the top of the list. Most people have little or no cash available, spending every dime they make each month. This works fine so long as nothing happens. Eventually though a car breaks down or an injury occurs, requiring several hundred dollars right away. At that point many people pull out the credit card and start keeping a balance even though they swore they never would. If you have an emergency fund, you just pay the bill and then rebuild your funds over the next several months. If you can avoid ever going into credit card debt, you’ll have thousands of more dollars to spend over your lifetime.
An emergency fund is also critical for dealing with cashflow issues. For example, with the government shutdown at the start of this year, many civil servant employees found themselves with no paycheck for a couple of weeks. They were eventually paid, getting what was essentially an extra week or two of paid vacation. The issue though was that they had bills due while they were waiting for their free back pay. With an emergency fund, it was no big deal since the bills could be paid from the emergency fund while waiting for the shutdown to be resolved. Another thing that commonly happens is for you to need cash to cover something like a business trip or purchase for your company and then wait for reimbursement. With an emergency fund, you’ll have the cash available so you won’t need to sweat the wait for finance to issue a check.
Finally, an emergency fund will allow you some time to find a new job should you be laid off or to pay for job hunting expenses if you’re looking for a job while you’re still working. Without funds in place you might need to pick a job quickly and then not have time to find a better one. An emergency fund will allow you the time needed to do a proper search and give you negotiating power since you won’t be as desperate to start receiving a paycheck again.
An emergency fund is normally built in steps, starting from the “baby emergency fund” (to steal a phrase from Dave Ramsey), then the full emergency fund, and then an emergency fund with an investment account on the side. Let’s go through each of these steps:
Baby Emergency Fund: A baby emergency fund is about $1000 in a bank savings account. This will offer little protection for a job loss but would let you put new brakes on your car without going into debt. This money should be used only for real emergencies – things you need for normal life – and not on things like vacations, meals out, and other luxuries. If this fund is depleted at all you need to go into emergency spending mode, cutting back on anything unnecessary until the account is replenished.
Full Emergency Fund: A full emergency fund is 3-6 month’s worth of expenses, or between $6,000 and $15,000. This money should all be placed in risk-free bank assets but some of the cash can be put in bank CDs to earn a little more interest. For example, if you have a $12,000 emergency fund, it is very unlikely you would have an emergency costing more than $2500, so you might keep $2500 in a savings account or a money market fund that you could access easily and then put $2500 in a 3-month CD and the rest in a set of 5-year CDs. If you had a significant expense that required more than $25,00, you could cash out the CDs and just forfeit a little of the interest. Again, this money should only be used for emergencies and be replaced quickly when spent.
Emergency Fund with an Investment Account: Once you have a fully funded emergency account, you should still continue saving some of your paycheck each month. On months when you have not spent anything out of the emergency fund you can direct that money to an investment account. The investment account will generate additional income and serve as further protection against a job loss or other event. Once the investment account grows very big, for example $50,000 or more, you can scale back your cash emergency fund a little because you can now tap your investments if needed for larger expenses. For example, if you have more than 3 month’s worth of expenses in your emergency fund, you could scale that back to 3 month’s worth and invest the rest so that you can get a better return on your money. This issue with keeping your full emergency fund in investments is that it is expensive to sell investments – that results in both brokerage fees and taxes – so it is better to have enough cash available to cover most emergencies with the investments as a back-up.
Finally, when an investment account gets really big – say more than $150,000 – some of the investment funds can be placed in interest and dividend generating assets to generate additional income. For example, corporate bonds and utility and bank stocks can be bought, which pay a return typically 4-6% more than a bank savings account. The interest and dividends can be directed into a money market account. So long as there is income coming in each month the emergency fund can then be reduced a little more. On months where there are no emergencies, the cash generated from the investments can be reinvested or spent for other expenses. On months where something happens, the cash from the investments will help supplement the cash in the emergency fund.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.