What should I have for an emergency fund? That’s a question I’ve gotten a couple of times over the past month or so. The rule of thumb says 3 to 6 months of living expenses. Seems easy enough. Just stash 3 months of living expenses into your checking account and you’re done. You just got paid and your balance is a couple thousand dollars…. guess that’s enough. Let’s move onto to investing in bitcoin, right?
Not so fast. That really doesn’t take care of it. Not even close.
First you should understand why you even need to have an emergency fund. It’s there as an insurance policy. To offer you protection when you need it the most. You’re fine paying your bills and throwing money into your brokerage account or retirement accounts, but what happens when the unexpected happens. There are two types of scenarios.
The “Freak Event” Scenario
Your car breaks down. Your furnace goes cold during the winter. Your air conditioning just blows hot air in the middle of August. You trip walking or fall off your bike and end up in the emergency room. These are freak events and they happen all the time. You can’t predict when they’ll happen, but trust me they do.
If you don’t have a reserve set aside to pay for the extra bills for the repairs, replacements, or medical deductibles then most likely you’ll end up sticking it on credit cards or selling some of your investment accounts to cover. Both potentially bad ideas. Why would you want to pay 12% to 18% (or worse, more) in interest to the bank for a temporary setback? Why would you risk having to sell some of your investments in a down market? We’re all confident that our investment accounts will be worth more in the future, however, the market can be volatile. You never know exactly when the market will slide.
The emergency fund is your buffer. Now the bank doesn’t get ridiculous amounts of interest for your short-lived setback. You don’t make things worse at a bad time by selling investments that have yet to bounce back.
The “Are You Kidding Me” Scenario
You got fired (lay off fits here too). The company isn’t doing so well and your stock investment plan at work is performing poorly. Not only your company stock but the market in general is headed in a downward spiral. This, to state the obvious, is not a good situation. You’re without a paycheck for a while and your investments and retirement accounts are all down significantly.
This happened to a friend of mine at the end of 2011. In his mind, things were going great. It was mid-December. He and his family had plans to take the last two weeks of the year off to celebrate the holidays in Hawaii. I was incredibly jealous of his vacation. So off he goes on this wonderful trip to return after New Year’s.
Unfortunately, the “Are You Kidding Me” scenario struck. While he was away, the company he worked for had a reduction. And, as you can guess, unbeknownst to him, he was fired in the middle of his vacation. Now the company did have the good sense not to reach out to him while he was away. Giving him that news would of course ruin it for him. However, the night before he was to return to work, he received a call at home letting him know.
It can happen. And unfortunately, it can happen when you least expect it. While you may be angry and upset that you’re out of a job, other than close friends and family, nobody else really cares. And by nobody, I mean your landlord, your credit card issuers, your electric company…. you get it.
This is not the time to cash out your 401(k). That’s the worst decision. Let me give an example. You may argue that it’s only $20,000 in the account and you need it to float you until you’re back on your feet. But it can be a crushing long-term decision. First, you’ll end up paying federal and state taxes and perhaps a 10% penalty if you’re under 59 ½ years old. As if paying 30-35% ($6,000 to $7,000) to the government when isn’t horrible enough, the opportunity cost is frightening. If you’re a thirty year-old and cash out, you’ll now have over $340,000 less in your retirement account at age 67 (assuming an 8% annual return). Not a good trade off – to get your hands on $14,000 after taxes and penalties now and have $340,0000 less in retirement later.
So, who’s got your back when the chips are down? Your Emergency Fund, that right. It’s there to give you some cover because you took the time to insulate yourself from this type of stuff. It turns a bad situation into an “ok, I can deal with this” situation. Because you have 6 months of expenses reserved, you can go about looking for that job without having to immediately worry if you’re going to lose your apartment or have the lights go out.
Where and How Much
This begs two more questions. Where do I keep my emergency fund and how do I know how much to put into it?
For starters, don’t put it into your regular checking or savings account. Your emergency fund should be kept completely separate so you are not tempted to dip into it for any reason other than an emergency. If you have several thousand dollars sitting in your checking account you could easily be persuaded that the last-minute get away your friends are taking is justifiably an emergency for you to join. Trust me, it’s not. This account is for those truly unexpected curve balls life occasionally throws at you.
There are plenty of online banks that offer low interest saving accounts or money market accounts that serve this purpose. Look for an account that you can transfer money to easily without any hassle. It will also make getting to your emergency fund easier when you actually need the funds.
Let’s face it. You’re not aiming to make money on this account. If you get a little interest each month that’s ok. If you take on a riskier account or investment, you’re gambling that the market will tank just when you need the funds and that’s self-defeating.
As for figuring out how much to put aside, there’s plenty of ways to attack it. For the Freak Event scenario, save and put away a $1,000. This should cover the blown tire, the replacement appliance etc. It’s an amount that gives you a quick cushion without having to go into debt with your credit cards.
For the Are You Kidding Me scenario, you need to get more serious as this can be, at first, a slightly more daunting task. I would suggest creating a list of your expenses that you’ll need to pay in the next six months. Having lost a job, you may not want to immediately start cancelling all of your subscriptions or services. You can start to do that in the second through sixth month to stretch out your emergency fund.
For younger folks just starting out, the basics are groceries, housing and utilities, insurances, and transportation. Groceries are just that. It doesn’t include dining out and take out. These are things you can spend money on when the emergency has passed.
You may want to also consider cell phone and internet/data expenses in your calculation. For some, it can be a shock when you realize your company phone has to be handed in and you need to go out and get a cheap phone and cell plan. You’ll need these as a tool to stay in touch with potential employers as you search for your next job.
I’ll also caution you to beef up the medical insurance expense when planning. While you may be able to use your former employer’s plan through COBRA coverage for a period of time, the cost will soar. You’ll end up paying the entire cost of the coverage including what your former employer paid and perhaps a premium as well. It can be a rude awakening to the true cost of medical coverage.
As you get older or have other family members to worry about, you can expand the basic list to cover more of your expenses. Day care comes to mind. That’s not something I would think to cut immediately as you’ll want to focus on your job search and not be too disruptive to the family routines.
After listing everything out with the monthly cost, add them up and create a goal to get one month’s amount tucked into that online account. Then give yourself a quick pat on the back and re-focus on two, three, and four through six months. Celebrate your milestones by sharing your successes with your trusted friends and family. It can be invigorating to have your support team cheer you on.
Remember your emergency fund is your own insurance policy to insulate you and your investments from life’s jolts. Without it, you risk turning a financial annoyance into something much bigger and with potentially serious long-term consequences.
Have you set aside money for your emergency fund? Can you weather a storm for several months? Share your experiences and thoughts in the comments below.
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