The Emergency Fund: Insurance for your Financial Life

I don’t think any personal finance blog, advice column, or book is complete without a post on the emergency fund. Articles and advice can range dramatically, from $400 to 12-months of spending. It is amazing how many people in the US couldn’t cover an unexpected $400 expense.

It can be difficult to know what the “right” amount to have in an emergency fund is (or if you need one at all), but there are several factors that you should consider when setting your savings target.

  1. Spending: More specifically, fixed spending. Everyone’s monthly expenses are going to consist of things that they are locked into, at least in the short-term, like rent/mortgage, utility bills, basic groceries, etc. The rest, like eating out, your standard morning Starbucks coffee, etc. could be considered variable costs. In the event of an emergency (ex. job loss), the variable expenses are easy to cut out, while the fixed costs are going to happen no matter what. Understanding how much of your budget is fixed versus variable will help decide how much you need saved in an emergency.
  2. Quality of Income: Are you a rising star in your company in a growing industry, or has your company been slowly laying people off? Are there other companies nearby that you could easily find similar work, or are they the only employer around? Does your partner work as well or are you a single-income household? These questions are important for knowing how quickly it could take to recover from a financial setback. The longer it takes to recover, the greater your need for a large emergency fund
  3. Access to Credit: While credit card debt is one of the worst kinds of debt you can have, the month-long delay between the closing of a bank statement and when the payment is due can buy you some time to recover from a financial setback. If you own your home, HELOCs (Home Equity Line of Credit) can also be used to cover your expenses. Note though that banks may not let you open a new HELOC if you have no income, and so this will only work if you already have a HELOC.
  4. Investment Portfolio: Having a sufficiently large investment portfolio could act as your emergency fund, though there is some risk to doing so. The largest risk is around timing. Often, the greatest chance of losing one’s job is during a recession, which is also when stock markets tend to be low. Therefore, you’re pulling money out of the market at exactly the time when you should be putting more in. If the amount you need is large compared to the portfolio you have built, this could mean a larger-than-necessary setback to your long-term financial health. However, if your investment portfolio is large compared to your emergency fund needs, it may have a much smaller impact.
  5. Peace of Mind: Money has the odd characteristic that it is extremely emotional for a large segment of the population. Therefore, an important outcome to consider when saving your emergency fund is the peace of mind it brings you. Life and finances should be about reducing stress whenever possible to greater enjoy the life you have built for yourself. If you derive a tremendous amount of comfort knowing that, should the worst happen, you have the flexibility to cover 3, 6, or 12 months of your expenses, then that is honestly the most important consideration.

How did the NFF family rate in these criteria to determine our emergency fund size?

  1. Spending: Our budget is about 2/3 (67%) necessities and 1/3 (33%) variable costs. Therefore, for every 2 months of spending we have saved, we could probably stretch into 3 months of spending in a pared-down emergency.
  2. Income: We are a dual-income household in 2 different industries, which does reduce the risk for us losing our entire household income. However, given the cuts in government spending (Mrs. NFF’s job is tied pretty closely to the federal government), the risk of losing at least some of our household income is relatively high.
  3. Access to Credit: We have a couple of credit cards with credit lines that would provide several months’ worth of flexibility. However, I would like to avoid that scenario as much as possible. We currently rent our apartment so there is no home equity to tap into.
  4. Investment Portfolio: Most of our investments are in retirement accounts (401k’s, Roth IRAs, etc.) so accessing these funds would be difficult. While they make up a good portion of our overall net worth, the risk of needing the money when the markets are down is too great for my taste.
  5. Pease of Mind: I am definitely what some would consider a “planner”. This means that, for me, it’s not a question of “if” I will need my emergency fund but “when”. So, having a healthy emergency fund allows me to rest easy and look forward to a down market as an opportunity to invest without thinking about the probability of needing that money at the wrong time. A side effect is that, because I have this cash cushion, I feel more risk-seeking with my actual investments. This has allowed me to take on more risk and get higher returns from the investment side of my portfolio.

Considering these factors, we have 4 months of spending (6 with slimmed-down spending) set aside in our emergency fund.

What are your thoughts on emergency funds? How much have you put aside?

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