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The emergency fund, or more affectionately, the “oh shit” fund is a requirement in sensible personal finance. Anybody that is alive knows the following quote:
What can go wrong, will go wrong. ~Murphy’s Law
For this reason among many others, it is only sensible to build an emergency fund. For those days where the shit hits the fan, and you need the extra money to fix things up, the emergency fund is there.
Why do I need an emergency fund?
Shit happens. As a Boy Scout, the motto we follow is “Be Prepared.” This motto is exactly the reason to build your emergency fund. Something will eventually happen when you need access to a large sum of cash, and it’s better to have it on hand then have to go scrounging around and begging to get it.
There are many, many things that can go wrong in life that an emergency fund can give you a little peace of mind for.
- If you lose your job, the emergency fund can get you through until you find a new one. This is the top reason why people have huge amounts of money in their emergency funds, and it all comes down to the fact that they don’t trust their employers and the economy to keep them employed. An emergency fund can give you the peace of mind to not worry as much about losing your job because you are prepared.
- An emergency fund can help you pay your medical bills should you manage to hurt yourself. The human body is an amazing machine, but it is also fairly fragile. When you manage to break it, there will be a need for money on hand in order to fix it. The more extreme you are in using your body, the more likely it is to get injured and need repair. Health insurance is supposed to help you out when you are injured or sick, but you cannot always count on it. You will at least have to cover the deductible, which on bad plans can be upwards of $12,000.
- Owning a home means you will have to cover the cost of the inevitable repair down the road. Oh, the joys of home ownership… At some point, you will spring a leak in the roof or a pipe will burst to cause minor or major damage. It will be on you to cover this and the emergency fund can help.
- Insurance also does not cover all of your car repairs. If you are smart and bought your car outright, then you probably don’t have comprehensive coverage. Everything breaks. Everything wears out. Eventually, you will have to cover the cost of repair of your vehicle and it always seems to be super expensive. Learning to do it yourself can save you thousands, but you still need money to cover parts.
- Basically, you just need to know that Murphy’s Law is true and that eventually, you will need the money from your emergency fund for whatever the mishap ends up being.
How much do I need?
This is probably the most common question when it comes to emergency funds. And the answer, I’m sorry to say, is it depends.
The usual advice is you need 3-6 months of living expenses in your emergency fund. This seems a little excessive to me because you can always sell your investments if you really are in an emergency. The average family has to pay rent, utilities, insurance, taxes, etc, every month. This amounts to $3,000+ per month of expenses. When multiplied by 3-6 months, we are looking at a minimum of $9,000 in your emergency fund.
$9,000 is a reasonable amount in your emergency fund, but as an atypical family, we have only $5,000 in our emergency fund. Spread across all of our cash accounts is near $9,000, so I guess you could consider us having $9,000 in emergency liquid assets. We came to China with $20,000 in our emergency fund, but after realizing that we spend very little and there really isn’t anything that could reasonably happen here that would require $20,000, we invested it in the stock market and brought ourselves down to the sensible $5,000 we currently have.
Where do I keep my emergency fund?
Under your mattress, of course…NOT. An emergency fund is supposed to be a fairly liquid asset so that it can become ready cash for spending as quickly as you need it. You can keep it in a regular checking account, though the interest here sucks! Better than a checking account is keeping your emergency fund in a savings account at one of the banks that is offering 1% or better interest. Yes, there are a few out there, think Ally and the like. Even better yet, is to keep your emergency fund invested in a
Even better yet, is to keep your emergency fund invested in a total market index fund like VTSAX. Many people will discourage keeping your emergency fund invested because of the risk of the value going down, but keeping it in your brokerage account with your other taxable investments is no problem. If you are worried about having quick access to your money, just ask yourself this question:
Is <insert situation here> so dire that I cannot wait 1 day to get my money out of investments?
If you answered yes, then you should keep your emergency fund at a bank in a savings account. However, if you can wait one day to have the money, then you can keep your money invested and have the power of compound interest. Your $10,000 originally put into your emergency fund and not used for 5 years can have the chance to grow and be worth $12,762 assuming a modest 5% annual growth.
The other concern keeping your emergency fund invested is a loss of value. Yes, you can lose money if your emergency fund is invested. However, because it is commingled with other taxable investments, you can dip into savings during an emergency. That is what money is for!
Should I build an emergency fund while I am in debt?
Absolutely, yes! While you are in debt is the time when having an emergency fund is most important. It is probably more important to start building your emergency fund modestly than it is to lay extra money into slashing your debt.
When I graduated college, I had $30,000 in student loans to pay off. When I started work, I had $13 to my name in all of my bank accounts, $30,000 of student loans, and certainly no emergency fund. When I started work, I did my best to be an atypical penny pincher, which drove my ability to build an emergency fund at $500 per month and pay off the student loans at double the minimum payment. I continued on that path until I had $10,000 in my emergency fund, at which point we turned to more aggressive retirement investing.
So, yes. Having an emergency fund is very important when you are in debt. When you have lots of debt, it is quite likely that you cannot afford for anything bad to happen. This is the time when Murphy’s Law is most likely to occur.
Having a cash/investment cushion will give you the peace of mind to continue crushing your debt.
Where do I find the money to build an emergency fund?
I assume you have a job. If you do and you also have no extra money to build an emergency fund, stop buying crap! We all have extra money, we just have to look.
Check out these posts for more info:
Living in China has really opened my eyes to how people can save. I see some of the poorest workers, street cleaners and vegetable stand workers, with the latest iPhones. The way they are able to afford those is through saving for a year or more so they have enough money to buy their one frivolous item. It just goes to show, if you put your mind to something you can find ways to save.
Can I just use credit cards for my emergency fund?
Yes, you can, however, there is really no need to go into debt. Having even a modest emergency fund can give you the buffer you need to not have to use a credit card for emergencies. You can and probably should use your credit card up front to gain points, but when the bill comes having your emergency fund will allow you to pay the bill in full.
Insurance is my emergency fund, right?
Insurance can help to cover you in the case of emergencies, but insurance is really in the business for profit. They are not in the business of helping us out first. Even if you can have insurance cover your emergency, chances are that by the time they “cover” your expenses, it is 2 months later. You will have to pay the cost of the emergency first and then get reimbursed by insurance.
The emergency fund or the “oh shit” fund is a great way to give yourself some breathing room. It allows you to enjoy life without having to worry so much about Murphy’s Law. Boy scouts is right using the motto “Be Prepared.” An emergency fund is simply being prepared for the eventuality that something bad happens.
Don’t listen to all the scare-mongers out there, that say you need X ridiculous amount of money in your emergency fund and it must all be in cash. Only you can decide how much is needed for you to feel secure.
The emergency fund allows you to live the atypical life, the free life, and know everything will be okay.
Do you have an emergency fund? How much do you have saved and where? Let me know in the comments.