Sunday, June 24, 2007

What is an emergency fund anyway?

A post about "How much emergency fund is too much" over at The Simple Dollar blog got me to thinking about my own emergency fund. How much should you have in an emergency fund? No Credit Needed says 12 months. Smart Money recommends 3-6 months. I personally feel a good 6 months is ideal.

But when I say I need 6 months of expenses, I'm thinking of what would happen if we had a sudden loss in income. A layoff, or illness, or anything that puts us out of work. 6 months of income would keep us afloat while we tried to rebuild.

Is this really an emergency fund? When I look at its primary purpose, I think its much more important than a simple emergency fund. For me, an emergency fund is for unexpected bills that suddenly come up, or small disasters that happen around the house. If my transmission fails and I have a $2k repair bill in my hand, that's an emergency. I need to have money that I can access pretty quickly. That convenience means that it needs to be somewhere like a high yield savings account, something with zero risk that is not going to offer very good returns.

The job-loss situation though is quite different. That's not really an emergency, its a temporary income replacement. It also has to have a principle quite a bit higher than an every-day emergency fund. 6 months of expenses. Is an "emergency fund" a one size fits all fund? I tend to think not. I feel you need to have 6 months of income replacement stashed away, but certainly you don't need to have access to it like you would a fund for smaller disasters. You can put it into an index fund or other safe but healthy return investment, and more than likely it will just sit there. Though layoffs are more common now, the chance of being suddenly fired is somewhat small.

The odds of my water heater dying, a tire blowing out, or something in the house breaking and needing replacement [insert any appliance here] is far more likely. I need to have that money pretty quickly. Even if I "floated" the balance for a month with a credit card, do I really want to dig into my income replacement fund for every day emergencies?

I say defining our emergency funds and splitting them into short term and long term safety nets is a better plan than lumping it all together into one.

How do you manage your emergency fund?

1 comment:

Jim said...

I define the emergency fund or EF as a way to avoid going further into debt (or waste money in fees) when I have access to cash to handle the emergency. With that being said, this is when all the options have been exhausted. This month the car insurance bill came and I panicked at first but felt calmed down because the EF was there so it could be taken care of. Then I started to think, once I take this money out it just has to be rebuilt later. So instead of making it an emergency, I included it the bills this month as something I would just normally pay.

An emergency fund should be 3-6 months of expenses, not income. What it costs you to get food, keep the lights on, put gas in the car, and pay the mortgage, etc. I think the term depends on the particular situation. If you have been employed under the same company for 20+ years, you could probably be fine with 3 months. Most people will probably need 6 month to hold them over long enough to find another job. If I lost my job (oops where did it go?) or became a victim of downsizing (layoff), it would not take me long to find another job. While I am looking though I would take a job doing just about anything (grew up mowing grass and landscaping) so I would at least bring in some money.

A good rule of thumb with when to resort to the EF is to think about it for awhile. It took me about 3 days to really consider the car insurance bill was not an emergency, it’s a bill that has to be paid. If a tire goes out, that is an emergency but the cost could come out of the budget instead of the EF. I don't save any extra money though because I'm trying to get out of debt first. Once I no longer have debt hanging over me, that money I am paying to debt will build my EF to a full 6 months, it's only 1k right now. I'll also be able to get more aggressive with funding retirement and hopefully one day ESAs for kids so they never have to meet Sallie Mae. Emergencies are different for everyone, it is going to rain one day, and a big umbrella will keep you dry.