Wednesday, May 30, 2007

Why build an emergency fund?

Everyone should have an emergency fund. This is not to say that there are not a few arguments that it is unnecessary. The popular criticism of having a large emergency fund is that with all of the credit available, you don't really need a stash of liquid low-yield investments sitting in a bank account. Those would do far better in other long-term vehicles.

I disagree. There are many ways to pay for that broken down car or that leaky roof, although 0% balance transfers and credit cards may not be the answer, as most of the credit companies have grown wise and are beginning to charge transfer fees (some in excess of 3% of the total balance). An emergency fund however is primarily to pay your fixed bills during a period of job loss. The higher your salary, the more important it is for you to have an emergency fund. Simply, the higher paying jobs are more in demand, far in between, and take longer to secure.

A guy working at McDonald's probably does not need an emergency fund of more than a few hundred dollars, to cover unexpected events like paying an auto insurance deductible. If he loses his job today, he can probably get another one within a week. A six figure corporate executive can't exactly walk into any building, fill out an application, and expect to be hired on the spot. It can take months, or even a year or more, to land a job - and it may not even pay as well as the last one.

The Two Income Trap describes this scenario very well. Families dependent on two incomes can, and increasingly do, end up in bankruptcy should a primary wage earner lose a job. They report a statistic that any given year a couple has a 17% probability of at least one of them suffering some kind of job loss. Those are pretty high odds for such a financial disaster.

An emergency savings fund should not be a part of your investments or your retirement portfolio. Once it is funded, it should just sit there and stew with meager interest until it is needed. This is why I advocate 2 emergency funds. One should be small and available instantly, like in a savings account with your bank. The other should be large and earning some interest but not locked away in a CD, mutual fund, or anything that could possibly sustain loss if tapped into. A high yield online savings account is my preference.

No, it doesn't maximize its earning potential. It's not supposed to. However if you do sustain a job loss or sudden reduction of income, you can continue living without cutting off the cable, stopping your retirement contributions, or playing games with credit cards.

How have I built my emergency fund? It is still in progress. I keep a thousand dollars in a brick & mortar bank earning paltry interest, something that I can tap into instantly, and I keep saving into a high yield savings account. 10% of my income goes into that savings. Once it hits its goal, which is $25,000, I can start putting 10% of my income into other investments or retirement. I already contribute 15% gross to a 401k, 5% after tax to a Roth IRA and 5% to debt repayment, so my emergency savings certainly doesn't hurt my ability to save otherwise. When I do have access to that 10% again, I can add it to my retirements or put it in some better investments.

If I do lose my job, I can pick up a lower paying part time one and make up the difference with the emergency savings account without increasing debt, reducing retirement savings, or cutting off services. Isn't that peace of mind and security worth having a little money that's making 5% instead of 8%?

1 comment:

Jim said...

Peace of mind is great in the event of job loss or serious injury. I think saving 30% of your income is beyond excessive if you still have debt. Being debt free seems more important in the sense that you wouldn't borrow money to invest or save and then keep making payments. Having a large emergency fund to cover several months of expenses is good to have though. For now a small emergency fund seems to be all that is necessary.

I only save about 5-10% of my income total between 401k, short term, and emergency fund. After the household expenses are met the money left over tackles the many payments to debt. If I did not have to make payments, not only would I be saving money on not having to pay finance charges, but the payments themselves could go directly into savings. It is more important to me to reduce debt and free myself from it than stashing extra money into savings.