Why You Need an Emergency Fund

When discussing investing, it’s easy to get sidetracked into thinking only about ways to make money (ie. stocks, real estate, etc.) and forget about another mundane, but highly critical, aspect of having a stable financial future.  Emergency funds are boring. Ideally they just sit there and are never needed, but their importance cannot be overstated. The safety net of a solid emergency fund can mean the difference between a minor financial setback and a major financial disaster.   

As this post is being written, the world is in the midst of one of the biggest global crises in many generations.  The COVID-19 virus has spread across the globe, infecting millions of people and killing tens of thousands. The loss of lives is tragic, and those effects should not be diminished.  But the economic turmoil that it has caused is also shocking. It has shut down much of the global economy, many small businesses are in trouble, millions of people have lost jobs, and the stock markets have seen the first major correction in over a decade or longer.  In the time span of about 1 month, the S&P 500 fell over 30%. It has since recovered a bit, but nobody knows whether it will continue to fall or recover to its pre-virus levels. 

Maybe the most shocking thing about it is that just 3 months ago, nobody had any idea this was coming and certainly no idea that it would have the drastic effect that it has had.  But in most cases, whether it be a personal or a global disaster, you don’t see it coming in time. If you aren’t prepared for it, it can be devastating. 

All of this coupled with the fact that 69% of Americans don’t have $1000 in savings and 45% of Americans have $0 saved ¹ is a very frightening thought.  If these numbers are factual, what are all of these people going to do if they are the ones to lose their jobs?

Dealing with a crises like this can be extremely stressful; mentally, physically, and financially.  Having a solid emergency fund will help ease much of the financial pain, which will in turn allow people to focus more on physical and mental health.  On the flip side of that, with no safety net, think about the possible outcomes if you find yourself without any income.  

• You could go into credit card debt.  Running up commercial debt at the insane interest rates of most credit cards can be devastating to your future. 

• You could be forced to sell investments to help cover expenses.  If the crises is a global crises like this one, this is the absolute worst time to sell investments; when the market is down and you suffer all of those losses by selling.  Remember that you don’t lose money when the market is down until you sell!

• You could be forced to liquidate 401K or other retirement accounts.  This is even worse than the previous bullet, since you will not only lock in the losses but will also likely be forced to pay early withdrawal penalties.

• You could stress out and put your mental and physical health at risk.  It’s hard to put a dollar value to this, but one could argue that this is the worst of all of these outcomes.  

Whether you already knew the importance of an emergency fund or you now realize it because you’ve seen the impact from COVID-19, let’s establish some ground rules for a solid emergency fund.

A good emergency fund should:

Provide 6 months of emergency living expenses

Now, before you go and say “6 months!  There’s no way I can do that!” let’s discuss a few things.  Most peoples’ day to day spending includes a few luxuries, like meals at restaurants, gym memberships, and travel.  In a time of crisis, if we find ourselves without jobs, these luxuries should be the first thing to go. Figure out your “limited” 6 month budget without those luxuries that you would be willing to temporarily put on hold and add a little extra for conservatism.  This final number will likely be about 4-5 months of your full spending or about 6 months of your limited spending.

Be 100% liquid and 100% safe

The emergency fund does you no good if you cannot access it.  Our preferred place for an emergency fund would be a boring savings account.  Since it is a pretty substantial amount of money and it will (hopefully) be sitting for a long time, it is worthwhile to try to find a high yield savings account.  Interest rates are falling at the moment, but there are still accounts that will pay 1% interest or so. Online banks, like Ally typically have very competitive interest rates because they don’t have the overhead of brick and morter bank locations. 

The money in your emergency fund should not be gambled with.  It should not be put into anything that has risk of losing value.  The point of having it is so you can use it at a moment’s notice, sometimes when you least expect it.  Bank savings accounts are insured by the FDIC for $250,000 per depositor per bank², so that easily satisfies this bullet.

NEVER BE TOUCHED UNLESS IT’S AN EMERGENCY

This one can’t be stressed enough.  And it also should go without saying, but for some people having a large amount of cash sitting in a savings account is just too tempting to pass up.  You must refrain from using this to buy the Black Friday TV that just went on sale or the engagement ring for your sweetie. It is critical that this money is there when you need it, so please, please, please do not spend it frivolously.  If you typically find yourself blowing your monthly budget and dipping into your “emergency savings”, one could argue that you have a spending problem and not an emergency fund problem.

Now that the ground rules have been laid out for an emergency fund, it’s time to talk about how to get started.  

1. Open a bank account separate from the ones you use for your regular spending. By using a separate account, you will more easily keep track of your emergency fund and be less likely to accidentally spend it.

2. Start placing any surplus money you have in that account. There is no better time to start than now. The sooner you get started the better.  

3. Determine how much your monthly spending is and multiply that by 6. This step is purposely after step 2.  If you wait to start until you figure the exact number out, you may never get started.

4. Continue to put money in this account until you have reached that goal. Once you see the amount of money growing every week or month you will be more motivated to continue saving.

There are many great resources out there covering this topic.  Dave Ramsey has discussed it extensively and has a great 7 step plan for getting your financial life in order.  He calls the plan his “baby steps.” Two out of the seven steps in his plan are related to emergency funds. That’s how important this is.  We highly recommend reading Dave’s book, “Dave Ramsey’s Total Money Makeover” if you need some advice on getting your financial life back on track.  

One thing to note is that saving for an emergency fund is only possible if you live within your means; that is, you spend less than you earn each month.  It makes no difference whether you have a high or low income, but if you spend more than you earn you are setting yourself up for disaster. It most likely indicates that you have some form of consumer debt to bridge the spending gap and will likely never be able to contribute to an emergency fund.  If this is the case, this is something that you need to start correcting today, and Dave Ramsey’s book is definitely something you should read.  

Now for some promising news.  The worst is usually not as bad as you catastrophize in your head.  Usually there are some ways that you can make your 6 month emergency fund last even longer if you need to.  For some people, unemployment benefits may help supplement some of your expenses so that you won’t need to withdraw as much from your emergency fund.  If you do not qualify for unemployment, a part time job or lower paying job could help close the gap. In the case of COVID-19, many people are getting aid from the government through stimulus packages (though this case is the exception, not the rule).  Additionally, if you find yourself unable to pay rent, you should contact your landlord proactively to have a discussion and not wait until the rent is due. This will go a long way with your landlord and they may be amenable to setting up a temporary reduction in rent and a payment plan to get you caught up in the future. 

If you are tired of the anxiety of not knowing what you would do if you lost your job or had a sudden crisis and needed money, building an emergency fund is a great way to alleviate much of these concerns.  It may seem daunting at first, but that is the case with most things that are worthwhile. Take small steps towards the goal each day and you’ll be surprised at how quickly it can add up. Remember, the next several weeks, months, and years will pass regardless of whether or not you start saving.  Wouldn’t you rather get to the end of that time with some financial security?

Disclaimer:  This article is intended to be a general resource only and is not intended to be nor does it constitute legal or professional advice.  Any recommendations are based on personal, not professional, opinion only.

References:

1. Backman, M (2019, Dec 18). The Percentage of Americans With Less Than $1,000 in Savings Is Shocking. Retrieved from https://www.fool.com/retirement/2019/12/18/the-percentage-of-americans-with-less-than-1000-in.aspx

2. Deposit Insurance at a Glance. Retrieved from https://www.fdic.gov/deposit/deposits/brochures/deposit-insurance-at-a-glance-english.html