FI Step by Step: Step 6, Establishing an Emergency Fund

Step 6: Establishing an Emergency Fund

Establishing an emergency fund is step 6 of my recommended 12 step path to financial independence (FI).   After you make sure you are properly insured against catastrophe, I believe the next order of business is to create some form of liquid cash reserve that you can access in the face of unexpected financial events.  This could include a whole host of surprises ranging from an expensive car repair to an appliance that needs to be replaced to losing your job.  

Today I’d like to try and address 3 basic questions in regards to an emergency fund: 

1. Do I really need it?
2. How much do I need?
3. Where should I keep it? 

With that, let’s dive in and get started.  

Do I Really Need an Emergency Fund? 

The traditional recommendation from most financial planners, investment advisors, books on personal finance, blog posts, etc. is to have a cash reserve equal to 3-6 months of your expenses set aside for emergencies.  Most people would probably say, WOW! that’s a lot of money to save up.  And they’d be right.  Saving enough cash to cover up to 6 months of all your expenses is A LOT of money for pretty much anybody.  Is that really necessary?  Let’s explore that question a little further.

I have actually had some mixed feelings on this subject over time.  I understand the comfort and peace of mind that come with having a stash of cash for a rainy day.  However, I also keenly understand the opportunity cost of not having that money invested in something that could be making you money over the long haul, especially if it is a large sum (like 6 months of expenses). 

Over the last year I have actually seen an increasing number of blog posts in support of having little to no emergency fund at all!  This is generally recommended for higher income earners with a very stable job and paycheck, paid off debts, and a significant sum of money in accounts that may be less liquid than savings accounts, but still accessible without significant fees, such as a taxable brokerage investment account.  The rationale for this is that the opportunity cost is too high to have 3-6 months of expenses set aside in a low interest bearing savings account and if you are financially stable, you should be able to find ways to fund an emergency, like selling some of your investments if needed.  

The more I read these arguments against an emergency fund, the more they started to resonate with me in my current situation.  I am employed by my hospital and receive a paycheck every 2 weeks.  After 15 years of training and hard work, it is admittedly a pretty nice paycheck.  I feel pretty secure in my job, we don’t have any consumer debt, we have good insurance across the board, and we have a significant amount of money invested outside of our retirement accounts in a taxable brokerage account.  I felt like any unexpected “emergency expense” that came up we could handle by putting it on a credit card and paying it off within a couple of weeks when I received my next paycheck.  If the expense exceeded the amount in my next paycheck, I could sell some of our investments in the taxable brokerage account and have the cash within 48 hours.  Thus, other than a baseline amount of money in our checking account, I decided not to have a savings account set aside for emergencies given the opportunity cost.  

It all seemed like a pretty reasonable plan given the aforementioned factors.  I felt like we were well positioned to handle any “emergencies.”  But then, as it always does, life happened.  Something that I had not anticipated as an emergency occurred, and it has caused me to change my thinking on having an emergency fund.  Here are the 3 lessons I learned from this experience.

Lesson #1:  You cannot anticipate all possible emergencies

Earlier this year a family member called me and was in a bad financial situation.  The bottom line was that they needed help and it required cash.  This was not an emergency expense that I had anticipated when going through possible scenarios that would necessitate using an emergency fund.  Nor had I seen this type of emergency discussed in any of the books or blogs I had read.  It really took me by surprise.  So lesson #1 that I learned is that you just cannot anticipate all possible emergencies.  I suppose it was naive to think that I had thought through all possible scenarios that might require an emergency fund.  

Lesson #2:  Some things require cash

My personal plan to address emergency expenses was to use a credit card to cover any unforeseen costs, and then pay it in full when my next paycheck came.  And if that was not enough to cover the cost, I would sell some investments in our taxable brokerage account.  Well, this plan just wouldn’t work in this scenario.  If we were going to help out, we needed cash.  We couldn’t use a credit card to remedy the problem.  Again, this was something that I did not anticipate.  So lesson #2 was that some expenses can only be paid for with cash, and it is probably a good idea to have some cash readily available for such situations.  

Lesson #3:  Know thyself

As I thought through our options of how to get some cash to help the situation, I thought about selling some of our investments in our taxable brokerage account, as was part of our original emergency fund plan.  But as I contemplated this, I was very surprised at how reluctant I was to do this.  I thought it would be no big deal to sell some of our shares of VTI or VXUS to access some cash.  Yet, somehow I felt like I was making a huge financial mistake by selling some of our investments.  At the very core of my financial philosophy is a very strong belief in a buy and hold strategy.  This felt like it was in direct violation of that belief.  So lesson #3 is to know thyself.  I now better understand myself as an investor and realize it is not a good plan for me to have our investments be the primary source of our emergency fund.  It may work for others, but not so well for me.

So what happened?  Well, we happen to have a high interest checking account where we bank.  The cash in our checking account happened to be enough to cover this particular emergency and it all worked out.   In the future I may post on the pros and cons of lending/gifting money to family or friends, but that is a discussion for another day.  

But the 3 lessons I learned from this experience really caused me to re-evaluate my stance on emergency funds.  

So what is the right answer to the original question?  Is an emergency fund really necessary?  Knowing what I know now, I would recommend that everyone have at least some sort of emergency fund (you probably could have guessed that based on the title to this post).  We simply can’t predict what challenges life may bring.  And some of those challenges require cash on hand.  Better to have it and not need it, than to need it and not have it.  

How Much of an Emergency Fund Do I Need?

OK, thus far we have discussed my reasoning for having at least some sort of emergency fund.  I would bet that most people would probably agree with this line of thinking.  But the more controversial question may be how much money should be inside that emergency fund?

There are a whole range of recommendations out there.  In Dave Ramsey’s Total Money Makeover, he recommends that you start with a $1000 emergency fund in baby step one so you can stop turning to credit card debt anytime something goes wrong.  After your debts are paid off he recommends you save the standard 3-6 months of expenses in your emergency fund.  Once again, most financial advisors, bloggers, and websites recommend the standard 3-6 months of expenses in your emergency fund.  Suze Orman, however, thinks everyone else in the financial world is short sighted and advocates for 8-12 months of expenses set aside for emergencies.  And as mentioned above, there are growing number of those in the FIRE community advocating for little to no emergency fund due to the opportunity cost.  Who is right?

Well, as you might guess, there is no one right answer for everyone, at least in my opinion.  While I feel strongly that everyone should have a least some sort of an emergency fund for the reasons listed above, the amount in that fund is probably a different based on a number of circumstances.  

Here are 5 basic questions I think you should ask yourself when trying to determine what might be best for you and your family when establishing an emergency fund:

How stable is your job?

I believe this is a big determinant of how large of an emergency fund you need.   Are you self-employed?  Are you paid based on commission?  If so, then your paycheck is less reliable, and you need more of an emergency fund than someone with a very steady paycheck.  

Is there a chance you could be laid off or fired?  While these things are difficult to predict, some jobs are certainly much more secure than others.  The more volatile your job, the more you need in your emergency fund.  

Do you work for the federal government?  When the federal government shut down in the recent past, those without emergency funds were in serious financial trouble.

Are you the only income earner in your household?  Households with only one income need to have more of an emergency fund than houses with multiple income streams.

What are your regular fixed expenses?

These are the expenses you HAVE to pay or you could lose your home, can’t keep the lights on, or can’t put food on the table.  Do you have a mortgage? A car payment?  Health or auto insurance premiums?  The more regular fixed expenses you have, the more money you need in your emergency fund.  If you don’t have a mortgage and your vehicles are paid off, then you need much less of an emergency fund.  

What expenses would you have to cover for an emergency and for how long?  

Consider what financial emergencies could occur.  For example, what if you became disabled?  Do you have short term disability?  Long term disability?  If you have long term disability, but not short term, then you better make sure you have enough in your emergency fund to pay for your expenses until the long term disability kicks in.  

What if you lost your job?  Is your skill set in high demand?  How long would you estimate it would take you to find a new job?  Do you have enough saved to cover expenses until then?

If you or someone in your family had a serious medical illness or emergency, do you have enough in your emergency fund to cover your health insurance deductible and out of pocket maximum, in addition to your regular fixed expenses?

What liquid assets do you have in addition to an emergency fund?

For the purpose of this discussion on emergency funds, I would consider liquid assets something you could get cash from without significant penalty in a relatively short period of time.  This may include your checking account, other savings accounts, a money market account, a taxable brokerage account, etc.  If you have a significant amount of cash in these types of liquid assets, then you likely need less of an emergency fund.

What is your comfort level?  

As I mentioned above, know thyself.  If you feel like 3-6 months of expenses is right for you and helps you sleep at night, then by all means, that is what you should do.  If you feel you have a very stable job, have few fixed expenses, and have a large amount of cash in relatively liquid assets, then you might feel much better with a smaller emergency fund so you have a lower opportunity cost with that money.  You need to figure out where you fall on this spectrum.

Where Should I Keep My Emergency Fund?

Finally, let’s discuss where you should keep your emergency fund.  There are a number of options for this.  Let’s discuss some of the principles to consider, as well as places it should NOT be.

Liquidity

By definition, emergencies happen unexpectedly.  And when they do, you usually need money right away.  Thus, you need to be able to access your emergency fund easily and quickly, which is the definition of liquidity.  

Checking accounts and savings accounts are very liquid.  You can write a check from the account or transfer funds within 24 hours.  A taxable brokerage account is also relatively liquid.  You could sell any mutual funds or stocks within the account and have the cash in usually 48-72 hours.  Other options could include a money market account or a CD (certificate of deposit).

Cash tied up in real estate investments or businesses is relatively illiquid and should not be considered part of your emergency fund.

Penalty Free

If you need to access your money for an emergency, the last thing you want to have to do is pay a 10-20 percent penalty to do so.  For this reason I would not consider retirement accounts, HSA’s, and 529 plans part of your emergency fund.  There are steep penalties (with some exceptions) for accessing these funds other than for their intended purpose at the intended time.  

Low Volatility

Once again, emergencies occur unexpectedly, and often at the worst times.  For this reason, you don’t want your emergency fund to be subject to market risk.  If you have to access your emergency fund and it happens to coincide with a bear market, you may end up losing a significant amount of money.  For example, if you had all of your emergency fund tied up in the stock market and you needed to access it during the 2008 financial crisis, you might have locked in 50 percent losses or more by cashing out to pay for the emergency at hand.  

Earn Interest

Ideally your emergency fund should be earning some interest.  Of course, there is a tradeoff between risk and return.  While the interest rates you can earn may be significantly lower when avoiding more volatile investments like stocks, you can still earn some interest on your money.  

If you kept your emergency fund in a regular big bank savings account it may only earn 0.03% interest.  That’s 100 times less than the average rate of inflation.  In fact, I just did a Google search and this is the rate on the Wells Fargo “High Yield Retirement Savings Account,” quite a misnomer if you ask me.  Their regular plain vanilla savings account earns 0.01%.  You can do better.

Compare this with an online bank high yield savings account.  At the time of this writing, the interest rates in these accounts vary from 1.5% to 2.3%.  It won’t make you rich, but at least you will be earning some interest and be much closer to keeping up with inflation.  

Diversification

Just as with investing, I believe there is value in diversifying your emergency fund.  This helps mitigate the sting of opportunity cost in some of the safer, but lower interest bearing accounts you might keep some of your emergency fund in.  Remember, every financial emergency that comes up will not deplete 100% of your emergency savings.  

For example, you could keep a certain amount that you would be more likely to need and use regularly in a high yield savings account.  Next, you could keep some of your emergency money in a series of CDs that might earn a higher interest rate than the online savings account.  Finally, you could consider a taxable brokerage account as part of your emergency fund for more extreme and/or prolonged financial emergencies that might require months of expenses be covered.  

Other strategies include incorporating credit cards and a home equity line of credit as part of a diversified emergency fund, but I’m not too excited about using debt tools as part of my own plan.  

Here’s What We Do

Keeping all of these lessons and principles in mind, here is the strategy we have come up with.  

We are using a combination of a high interest checking account, high yield savings accounts, and our taxable brokerage account for our emergency fund.  These are all liquid accounts that give us quick and easy access to our money that is penalty free.  The high interest checking account and high yield savings accounts shield us from market volatility, yet still offer a decent interest rate that is close to keeping up with inflation.  The taxable brokerage account harbors the most money, mitigating the opportunity cost of having an emergency fund since it is all invested in low cost passive index funds, and would only have to be accessed in extreme financial circumstances.  

Here are some of the specifics.  Our high interest checking account is with a local bank and pays 2% interest on a balance up to $10,000, with decreasing interest rates for balances above that, but never falling below 0.41%.  So not too bad for a checking account.  We try to keep a balance of $10,000 or more in this account at all times and it is our first line of defense against financial emergencies.  It has the added bonus of not having to worry about bouncing checks.  

Next are our online high yield savings accounts.  I have chosen to use Ally Bank.  They don’t have the absolute highest interest rates online, but after doing a fair amount of research, they have excellent reviews from their customers, no minimum balance requirements, and an excellent mobile user interface (which I think is extremely important and highly underrated).  I strongly believe there are more factors to consider when choosing an online bank than just whoever has the highest published interest rate that month.  

We have 4 savings accounts with Ally Bank, currently earning 1.70% interest.  One of the savings accounts is earmarked as our emergency fund, one for a future vehicle purchase, one to help take care of aging parents in the future, and one for real estate investments.  I also have a Personal Capital high yield savings account earning 1.55%, which we use to save for short term goals, like upcoming vacations.

Our second line of defense against financial emergencies is the Ally Bank high yield savings account specifically designated as our emergency fund.  To be honest, we haven’t yet decided how much money to put in this account.  For now, I am just making regular contributions with each paycheck to slowly grow it over time.  

Our third line of defense would be the other high yield savings accounts.  While these funds are designated for other purposes, in the event of an emergency they could easily be accessed and used if needed.

Finally, we have our taxable brokerage account.  This is by far the largest portion of our “emergency fund.”  Its true purpose is for retirement savings.  It has the highest rate of return, but also the most volatility.  I hope we never have to access it for a financial emergency, but if needed it is liquid and penalty free.  The only scenario I can envision us having to use this money would be if I were to lose my job for a prolonged period of time.  Other disasters, such as disability or death, are adequately covered by insurance.  

Conclusion

Today we have discussed the importance of having an emergency fund as you progress step by step towards financial independence. Here are some take home points to consider:

• It is important to have at least some sort of cash emergency fund.  Not for the things that you can predict, but rather for the things that you can’t.

• The amount in your emergency fund varies based on your job security, current financial situation, and other liquid assets.  This amount can change over time and should be something you re-evaluate regularly when you review your overall financial plan.

• I recommend you diversify your emergency fund in accounts that are liquid, have penalty free withdrawals, are not vulnerable to market risk, and earn at least some interest to try and keep up with inflation.  

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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