An introduction to Emergency Funds

Life is unpredictable. You may be laid off and be unemployed for a while. You may have an unexpected large medical expense. How do you intend to fund these unforeseen costs when they occur? Which sources of capital do you have readily available to pay for these expenses?

This is where an Emergency Fund comes in. It is the combination of tools you have at your disposal to deal with unexpected (large) expenses. An Emergency Fund gives you the ability to access cash quickly and at reasonable costs.

Emergency funds are usually mentioned as a prerequisite for investing your savings because:

  • you may have investments that you can’t quickly turn into cash. An example would be a a retirement account you can only withdraw when you are 65.
  • ideally you want to avoid being in a situation where an emergency forces you to sell your equities during a market downturn and registering a loss.
  • turning your investments into cash can result in high costs. An example could be a 5 year certificate of deposit with high withdrawal penalties.

How much money should you set aside for emergencies?

There is no exact formula to come up with right emergency fund size: everybody has a different financial situation and that needs to be taken into account. Like everything else in personal finance, you can take a rule of thumb as a starting point, understand the trade offs of the rule of thumb, and make the appropriate adjustments according to your personal situation as you get more confident.

The most common rule of thumb is to have between 3 and 6 months of expenses allocated to an emergency fund and to place it in a low risk store of value (e.g. savings account, certificate of deposit). By expenses I mean what you usually spend over that period (e.g. rent, transportation) and not your full salary.

This rule of thumb comes from the fact that unexpected unemployment may be the biggest financial emergency you may face and it may take you 3-6 months to find a job. You may choose to have a different emergency fund size by looking at the following criteria:

  • Job security – If you work for the State it is unlikely you will be laid off. If you have a permanent contract you have more job security than a freelancer. Do keep in mind, that even large companies which sound “safe” lay off employees during periods of financial distress. You can also consider the notice period arrangements you have: if you have a notice period of 2 months you have more time to react to the job loss than somebody with 2 weeks.
  • Job market – If you work in IT you may have an easier time at finding a new job than an architect.
  • Predictability of income stream – If you receive a regular paycheck your income is more predictable than if you are paid per project.
  • Eligibility for unemployment/social schemes – this rule was mostly created out of the experience in the US where the unemployment benefits may differ from where you live. You need to figure out if you are entitled to these benefits, how much you would receive, how much time it would take to receive them though.
  • Additional sources of income – An additional source of income can be a second job or a salary from your spouse which would be able to cover part or all of your essential living expenses.

Part of the challenge in understanding the appropriate size of an emergency fund lies in understanding which types of expenses it is meant to cover. Should it be an unemployment fund? Should it cover payment for a car accident? Should it cover your house’s repair? I like Humble Dollar’s approach of distinguishing between “unexpected but predictable expenses” through a “life reserve fund” and costs you hope to not face through an “emergency fund”.

Where should you store your emergency fund?

You need to be able to access your emergency fund quickly without incurring substantial costs. Ideally your emergency fund shouldn’t unexpectedly loose value at the moments when you need it the most. That is why emergency funds are usually held in low risk/low return vehicles like savings accounts, short term bonds, money market accounts, certificates of deposits.

Depending on the size of your emergency fund you may decide to have a multi-tiered emergency fund: where you store part of it in a low returns saving account that you can withdraw quickly and other part of it in higher return accounts (e.g. certificates of deposits) for which you need to wait a bit longer to withdraw.

At the simplest level you implement an emergency fund through low risk vehicles like a savings account. At a more complex level an emergency fund is more like a strategy for having access to cash quickly and cheaply for which you can use a combination of tools: it may also include credit cards, insurance, family support and bank loans. Looking at an emergency fund from this broader perspective may lead you to hold less money in a “classic emergency fund savings account”.

The money you set aside for an emergency fund won’t have stellar returns. That is fine since its primary goal is being readily available for an emergency while maintaining its value.

Do you need an emergency fund?

Not everybody thinks you should have an emergency fund “account”. Even if you decide to go that route it is important you have an emergency plan: an idea of which tools you will use to access cash quickly in the event of an emergency.
At the end of the day you should choose what will make it easier for you to sleep at night and commit to your investing plan.
If you are just starting out and not sure if you need one, I would suggest starting with the emergency fund rule of thumb (3 months expenses) and then adjusting as you understand your needs better.