An admission, our emergency fund is currently larger than is optimal. It’s crept up to that point and in the next few weeks I will be whittling it down. That has inspired this post. I have written in the past that everyone should have an emergency fund, but how large should it be? What form should it take? Is there such a thing as too large of an emergency fund? What is the optimal emergency fund?
Defining an Emergency Fund
Let’s start by defining an emergency fund is. According to Investopedia an emergency fund is a “an account used to set aside funds needed in the event of a personal financial dilemma, such as the loss of a job, a debilitating illness, or a major expense. The purpose of the fund is to improve financial security by creating a safety net of funds”. Sounds fairly straight forward, but there is a lot of gray area here.
What defines a personal financial dilemma?
The first question the definition raises is what defines a financial dilemma? Obviously by the definition it’s a major negative financial event, so it’s purpose is not to pay your month to month expenses as those would not be major. I would add to the definition that it is also primarily intended for unforeseen events. So for example 2 years ago we replaced the roof on our house. We knew going into our home purchase the roof needed to be done soon. Given we knew it was coming it was not an emergency expense. It was something we saved for ahead of time. I know, money is fungible so technically it can be the same funds, but trust me that I say if you have a foreseen major upcoming expense your better off saving for it ahead of time then counting on your emergency fund to pay the bill.
What form? How Much?
Beyond the basic definition and usage guidelines things get deeply personal, as most things personal finance. There are different choices, each with varying levels of accessibility, return, and risk. What you choose should be a factor of a few things:
- How diversified are your sources of income? If you have multiple large income streams and spend less than comes in, then you obviously are less likely to need an emergency fund for extreme cases of job loss. Major expenses like surprise home maintenance might be a different story, but these can usually be mitigated via your paycheck if your living below your means. Typically if you have a decent savings rate and good credit the biggest risk to insure against is job loss in a down market. Diversified income streams reduces that risk significantly.
- Do you have backup sources of funds should you lose your job? For example, I would receive a year of pay in the event of a layoff due to various contractual employer obligations. As such my risks are limited to actually being fired or my company going under. Both are much less likely than a layoff, so I might be willing to have a less liquid emergency fund. I’ll touch on this in a minute when we speak about my emergency fund.
- Your risk tolerance also plays a part. If you are generally risk averse you will likely sleep better with a larger fund. You cannot discount your psychology and feelings in this decision. If you do, you risk overreacting in a downturn and costing you major money.
Form: Return versus Liquidity
Once you know your situation you have to choose which form of fund fits your situation.
- At the most basic level you have a savings account. Personally I am not a fan because of the abysmal return but if you needed the funds the same day this would be the best choice. I have credit cards with a 30 day grace period, so this would never be an issue. If you have cards you do not need an emergency account in a savings account.
- Then you have bonds or bond funds. The return is slightly better but in my honest opinion too beholden to Mr. Market in the case of funds and too illiquid in the case of individual bonds.
- After that we have CD ladders. Typically you can get a ten year CD with a decent near 3 percent over inflation rate. Get a few of these and you build a ladder. The CD should have a low early withdrawal penalty where if rates rise or you need the funds in emergency you can withdrawal funds at the cost of a quarter or two of interest. This is the form we currently hold our emergency fund in.
- From here the risk ratchets up slightly to a home equity line of credit. If your pre approved there is some added risk if your provider increases your interest rate. There is also some counter party risk that like in 2008 your provider goes belly up or your house equity drops like a stone. Both are probably low likelihood, but it has happened not that long ago. If something did happen it would likely coincide with a job loss. Certainly a perfect storm, but still possible. I have repeatedly considered shifting to this method, but have not done so. My personal risk tolerance coupled with how I fund my emergency fund, which we will talk about in a few minutes, conspires to keep me at CDs.
- At this point the risk takes a leap forward to a taxable stock account. The risk here is a job loss is most likely in a down market, so your most likely to have to lock in stock losses if you need the money. Sure it has the best return, but for me the risk is not worth the return.
- Beyond the taxable account there are two more options, both related to tax advantaged accounts. I am almost loath to mention them as I believe they are a bad deal for anyone.
- The first is to take a loan from your 401k. The problem is you can only take a loan from your 401k while your employed. If you lose your job you must pay it back or face the 10% penalty. I do not feel raiding your 401k is a viable alternative
- The second is to take out principal from your Roth. This is a bit more palatable except once it comes out it can not go back in. Given I believe you should maximize any tax advantage space you can get, I feel this is a bad move unless you have an absolute last resort situation.
Obviously the form choice is up to you.
But how much should you put in? Most experts recommend around 6 months of pay, under the assumption you can find another job or gain access to another source of funds in this time. That being said as I noted that depends on how much you need that job. If you have alternative sources or a backup source of funds then you likely need less. If you have only one source of income in an area with limited employment opportunities and low savings you might need more. In any case it is a trade off. Your are trading the security of having those funds available in exchange for a lower return. Having too much can cost you significant return on your investment, so you need to keep these funds as low as reasonable given your personal situation.
How much is not a static question.
If you recall I started this post by mentioning I have too much in my emergency fund. Well, guess who had a single income in an area with limited employment opportunities while my wife was a stay at home mom. I live in an area where the largest employer is departing (Dupont) and most employers are smaller service type organizations. Meanwhile my skillset fits large scale international companies. If I lost my position at my current job due to an unexpected situation I would almost certainly be required to move. So my risk increased. Granted I did have a backup source of funds as I mentioned previously, but my risk level did increase for a time.
My Fund Increased Proportional to My Risk
During this period of increased risk I changed my emergency fund from my normal level of around 2-3 months of emergency funds to just over 6 months. This was compounded by the way I chose to do the increase. Instead of putting all the money into the fund over time, I instead created an automatic redirect from my checking account. For a time it helped me save by reducing my available funds, but it also led to me overshooting my original fund target of 5 months. I have since changed this scheme to direct extra funds instead to an employee stock purchase plan, a post for another day.
A Changing Situation and a Changing Emergency Fund
As you have read by now my wife is now a contractor making a large portion of what she made previously. This is almost enough before taxes to support our household expenditures, which means the risk has somewhat subsided. She will be working for the same company but a different division, so some risk still exists. However, we always worked for the same company, so it is no more then prior to her job change. Now that my risk has decreased somewhat I will be pulling back to 2-3 months of emergency funds. Given I have yet to do any bond allocations for the year, and I suspect a wave of additional stock purchases in a solo 401k due to my wife’s new contract work, the money will be placed on my mortgage.
What form is your emergency fund? How much money do you keep in your emergency fund? Why?