Do I Really Need an Emergency Fund?

[social_warfare]

 

Recently I followed a very interesting discussion in a Facebook personal finance group about if I really needed an emergency fund.

The answer that everyone hates in Personal Finance is “It depends”.  But what does it depend on?

Read on to find out if you need an emergency fund or if you can put that cash to better use.

Many personal finance experts advise us to have an emergency fund.   Things come up unexpectedly; car troubles or the fridge konks out or an unfortunate downsizing in your workplace.  These are the times when the emergency fund kicks in.

There are experts in the other camp too.  They reason that an emergency fund is an inefficient use of money.  They recommend investing that money to earn in the stock market instead.  They argue that most of us probably have enough room on our credit cards to cover a new fridge or a car repair.  In the event of a job loss or layoff, one could use the home equity to tie then over.

So who’s right?

I think those who propose investing the money has a point, but it’s not suitable for everyone.  Yes, everyone’s situation is different but there are some common themes to consider:

What kind of emergency are you saving for?

In my opinion, there are 2 kinds of emergencies; first is the kind that needs relatively smaller amounts of money like for car repairs and a water heater.

The second kind requires a lot more money; such as prolonged unemployment; whether it is layoffs or taking time off.

Probability of that emergency?

If you own a car, then you know that the first kind emergencies are more likely than not.  In this case, you’ll probably need access to the funds at some point.

The second kind of emergency, prolonged unemployment, the probabilities depend on your company and your industry.  If you work within a union or work for the government, those probabilities are smaller than if you work in the service industry like hospitality or travel.

However, if you are planning a short leave from work like if you are trying to get pregnant, or if you are like me and suffered from burn out, then you are also going to access that emergency fund.

If you assess the probability of the emergency occurring is high, then keeping the fund in cash is a safe bet.

How likely you can replace your current income?

It is easier to replace a $35K/year income than it is to replace a $135K/year income.  That is because, at the $35K/year level, you might be able to cross into another industry that pays the same.  But if you are making $135K/year, you probably have some specialized skills that aren’t as easily transferable.

That said, this is relative to your fixed expenses, really.  If you usually earn well in excess of your living expenses, you are in a better position to put that smaller emergency expense on your credit card. You could likely pay it off in one or 2 pay cycles.  You are probably in a better position to replace your employment at a lower income, even if that’s not your ideal scenario.

If you are able to easily replace your income or your fixed expenses, you won’t need a large emergency fund. The rest could be invested for longer-term gains.

Your Age.

If you are young, say in your 20’s, the emergencies will most likely be the short term stuff. You are more likely to be replacing things, rent deposits and the like.  For employment, it’s likely that you are in an entry level job and those are sometimes more accessible than the more senior ones.  In this case, the cash emergency fund is more of a priority.

If you are older and have a mid to senior level job, you’ve probably been making a comfortable salary.  In this case, the smaller stuff like replacing the fridge can be put on the credit card.  However, now it’s probably harder and takes longer to replace your income.

So if you are young and just settling in, you probably only need a small amount of cash, ie for first and last months rent and the like.  The rest, even if small, can be invested and let compounding work for you.

If you are more settled, you probably don’t need an emergency fund for the fridge but need one to tide you over while you look for another employment.

What kind of assets you need to protect: If you own and how many dependents you have.

If you own (mortgage) your home or have dependents, then you need to prioritize the protection your income stream.  You need to make sure you can still take care of the bills while you are dealing with the emergency.  In this case, you would want quick access to those funds and it is imperative that they don’t suffer losses.  Having it in cash will serve both.

How much assets you already have

If you have healthy investments, lots of savings, a home with equity and low expenses, then you can probably weather a lot of negative events. You have a lot of resources to draw from.  In this case, the emergency fund isn’t your only resource.

But if you are less secure in your assets, then you don’t want negative events to totally derail your plans of saving for retirement. You don’t want to pull out investments in bad markets.  Or even in good markets because you want to compound your investments.  So in this case, having an emergency fund for the short term and long term is probably a good idea.

To Have or Not to Have

In my opinion, most people should have an emergency fund.  At least for the smaller stuff.  If you are starting out, you’ll need the cash and if you are more established, having that in cash isn’t going to move the needle in your investments.

For the longer term emergencies, that’s more of personal preference.  I still recommend one.  It doesn’t have to be a 6-month emergency fund, especially if you have a high-risk tolerance.  It could be a smaller amount, maybe 2 to 3 months of expenses.  My view is that slow and steady is the way to invest and I don’t want things to interrupt the momentum.

Now your turn – do you have an emergency fund?  Why?  Or do you invest everything?