Everybody knows that they need an emergency fund (despite the fact that not enough people have them). Nobody wants the stress of being unable to handle a medical emergency, the loss of a job, or a car that needs repairs. But what priority level should your emergency fund be compared to paying off debt or saving for retirement? How much do you actually need to save? And should it be in all cash or invested? These are the issues we’ll be looking at today.
When to Start Saving
The loudest voice in personal finance is Dave Ramsey. Ramsey tells his readers and listeners to first save $1,000 in an emergency fund, then pay off all non-mortgage debt, then build the emergency fund to 3-6 months of expenses. And all of this before contributing anything to retirement savings.
If you’ve been around here for any length of time, you know from my framing of the last paragraph that I am about to disagree.
First on the priority list should be any 401k contribution that gets an employer match. If your employer matches 50% of your contributions up to 6% of your salary, then contribute 6% of your salary. Even if you don’t have an emergency fund.
Let’s look at the numbers. If your employer matches 50% and you contribute $1,000, you get a guaranteed return of $500. If you contribute that same $1,000 to your credit card debt, you are saving yourself $200 on a card with a 20% interest rate (and that’s assuming that it would take you a full extra year to pay off that $1,000 otherwise). If you put that $1,000 into an emergency fund in a high interest savings account giving 1% interest, you are getting a return of $10.
Okay, so the match is the best return and needs to be taken care of first. What next?
My position is that the next step is to pay off all of your high interest credit card debt.
“Without any emergency fund saved up?” you may be asking.
“Indeed,” I would respond in this imaginary conversation. And it comes down to interest rates again.
Even a credit card charging a low 10% interest is going to cost you 10 times more than what a 1% savings account will save you.
Of course, the point of an emergency fund isn’t to get the best return on your money, but to prevent you from having to go into debt in the case of an emergency. But if you have balances on your credit cards, then you are already in debt! You already had the emergency that you are saving to avoid!
If an emergency happens while you are paying down your credit cards and before you have saved an emergency fund, then you will put it on your credit card. This will be annoying and will feel like a step backwards. It will be frustrating seeing your balance go up that month instead of down. But it does not make any sense to set aside money to pay for emergencies in cash when you are carrying a credit card balance.
How Much to Save
The next question to tackle is how much you need to save. Ramsey says to save 3-6 months of expenses. Susie Orman, the other loudest voice in personal finance, says to save 8 months of expenses. The various rules of thumb tend to range from 3 months to 6 months.
My answer: it depends.
(Come on, you had to see that coming.)
We’re not big fans of rules of thumb around here. This one is better than the rule of thumb regarding retirement numbers, but still could use some more flexibility and personalization.
If you work as a freelancer or run your own business and income varies drastically from month to month, then you want a larger emergency fund. If there is a legitimate chance that your income will drop drastically for a few months at a time, then you need to compensate for that risk with a larger emergency fund.
At the other end of the spectrum, if you are part of a two income household in different fields and both jobs are very secure, then you can save a lot less in your emergency fund. (I specify different fields because if you work in the same company or field then your risk of both being fired at the same time will increase if that company or field starts to struggle.) If it is not likely that either of you would lose your job without warning and extremely unlikely that both of you would lose your job at the same time, then you can adjust for that with a smaller emergency fund.
Assess your own risk level. And don’t underestimate the risk of losing your job. Remember that we are in an age of rapid technological growth and that no job is 100% safe.
The other factor to consider is your stress level.
The benefit of keeping a smaller emergency fund is that you can put more money into the market where it can grow and build your wealth. Think of your emergency fund as defense and your investments as offense. The emergency fund protects the wealth you have, while investments grow your wealth.
If you would sleep better and have less anxiety from having more defense at the expense of extra offense, then go for it. Just recognize that you are paying a growth premium for that peace of mind. For many people it is worth paying that premium. For me? Not so much.
Should You Invest Your Emergency Fund?
So if you need to be in the markets to grow your wealth, then why bother with an emergency fund at all? Why not just throw everything into the market, and then withdraw money when you have an emergency?
I have actually gone back and forth on this and I think both sides are defensible.
Personally, I keep a cash emergency fund in a savings account. I recognize that I am giving up growth here, but I am okay with that. First, having cash means that I don’t have to risk selling in a down market and buying back in after the market has recovered. Second, the emergency fund is such a small part of your long term investment portfolio, that I don’t mind having it in a savings account for peace of mind.
That said, I can’t say I haven’t been tempted to invest that money.
One of the better-argued cases for investing your emergency fund is made by Betterment. Betterment suggests figuring out what you think you need in your emergency fund and then adding 30%. Once you have this 130% emergency fund, invest it in a portfolio of 60% bonds and 40% stocks. The extra 30% means that in the vast majority of simulations, your balance will not drop below the 100% line.
Take a look at Betterment’s argument and think through your own comfort level before making a decision with what to do with your emergency fund.
My personal rule of thumb would be that if you aren’t sure, leave it in cash*. But you know how I feel about rules of thumb.
*But only for your emergency fund! For everything else, you need to be investing!