Before I begin, I want to say that I’d be OK with much of this being wrong and take criticism very well. Please don’t be shy in the comments or otherwise.
A lot has been said of late about the emergency fund. A few examples from blogs I read (blogs that you should read too):
- “Why an Emergency Fund Isn’t Necessary for Me Right Now” on Girl Meets Debt
- “Do you have an emergency fund?” on Johnny Moneyseed
- Pauline at Reach Financial Independence wrote, “A forced emergency fund”
I agree with everything that was said here, despite the disparate answers. In particular, I like that each discusses steps they would take in an emergency meaning that they have more than just an emergency fund; they have an emergency plan, which can be more important anyway. Even more generally, the “personal” in personal finance means that no two people have the exact same goals nor should they arrive at the same solution.
And so the four biggest factors I took into account when I determined how much to keep in my personal emergency fund were:
- The definition of, and costs and benefits of an emergency fund
- The volatility of my current situation
- The lifestyle adjustments I would make in an emergency
- Non-cash vehicles in which I could keep some of my emergency fund, and the desire to keep building retirement funds
All of these led me toward cash reserves that are smaller than you might guess.
1. What is an emergency fund and what are the costs and benefits of keeping one?
In my case, it’s money I keep liquid enough to be accessible in the event of unforeseen short- or medium-term expenses such as job loss, health emergencies, emergency travel, or bail money.
Besides the psychological aspect of forced savings, the benefit I get from my emergency fund is access to inexpensive cash in these sorts of situations. The cost of keeping an emergency fund is the additional interest I pay to my student loan servicers because I’m keeping money from them.
2. I take the volatility of life into account
Determining the appropriate size of my emergency fund depends on finding the balance between the potential for an emergency, the potential size of an emergency, and potential duration of an emergency, and avoiding the very real 7.9% interest rate of my student loans.
Because my job, health, and need for immediate travel are fairly stable, and because I have no car, kids, or much that could break, I keep less cash around than I would if any of the three were noticeably volatile.
3. I assume I would change my spending — and earning — in the event of an emergency
This is probably my biggest pet peeve, and usually comes in the form of folks who calculate an emergency fund by putting away three or six months of their current income into a bank account.
Are these people saying they wouldn’t adjust their spending if they lost their job? Really?
On day one of becoming unemployed, I could trim every expense besides rent and utilities, and even those I could trim after a few months by negotiating with my roommates. By my math I could immediately cut my food, personal maintenance, and transit expenses in half; cut my entertainment budget to nearly zero; and drop the minimum payments on my student loan repayment by requesting a hardship deferment. Thus, in a short-term emergency, I would need just $1500 per month to get by, down from the $3800 per month I currently burn through (Over $2200 of that goes to debt repayment).
Of course, on the other side of the coin is income. While I look for another job, I could pick up short-term consulting contracts, cash in on unemployment insurance, and rely on other passive income.
4. I understand that an emergency fund can be held in vehicles other than cash and I don’t forego adding to my retirement investments to build up cash reserves
Because they would mollify the effects of different potential emergencies, my health insurance and big cushion of frequent flyer miles effectively function as part of my emergency fund.
Otherwise, because an emergency wouldn’t necessarily require immediate cash, I could keep some of an emergency fund in better earning but less liquid vehicles (In times of higher interest rates, I might even be satisfied keeping an emergency fund in cascading certificates of deposit that I roll over upon their maturity).
In this vein, I am particularly confused when I hear of people who do not fully fund a Roth IRA and do not taking advantage of employer match for a 401(k), in order to build or maintain cash reserves.
A Roth IRA is a retirement savings account with annual contributions currently capped at $5,500, in which earnings accrue tax-free under normal withdrawal, but from which contributions can be withdrawn at any time without penalty. Put very simply, not maxing out a Roth IRA in favor of holding onto cash is crazy because I cannot go back in time and turn cash into Roth IRA funds for previous years, but I can always turn Roth IRA funds into cash without penalty.
With the 401(k), my company also offers a company match up to 3% of my salary so it also wouldn’t make sense to skip this in favor of building up an emergency fund because I get an immediate 100% bonus on that money and I would pay less than a 40% penalty to withdraw it.
How much I keep
Add all these together, and my emergency plan consists of:
- The aforementioned health insurance
- The airline miles
- A Roth IRA that’s already maxed out for 2013
- A 401(k) to which I’ve already contributed the maximum amount my employer will match for 2013
- And enough cash to cover just two months worth of expenses at my current spending level, or $7600, in a high-yield account.
Alright internet, how wrong am I?