The emergency fund is nothing new in the financial world. Many of us bloggers pontificate on the need to maintain a proper emergency fund and rightly so. But why should we hold a bunch of cash that earns almost no interest? And how much should we hold? The answers to these questions are more complicated than we are usually led to believe yet the emergency fund is the cornerstone of a successful financial or investment plan. First, I’ll start with five reasons to have an emergency fund and then, in the next post, build into the factors that help determine the proper size of an emergency fund.
1. Keeps you out of debt.
Once the emergency fund is established alongside a realistic budget, the fund helps limit the need to pull out that credit card or take out a personal loan for unplanned expenses. While not all debt is bad, it’s essential that any loans come as part of a deliberate plan, not a surprise expense. The result is that the emergency fund allows a person to absorb a car breakdown or pay an insurance deductible after a storm damages the house without suffering debt repayment over the following months. Most importantly, it keeps people out of significant debt if they temporarily lose their paycheck.
2. Ends living paycheck to paycheck.
This reason is an extension of #1. People with emergency funds are no longer living paycheck to paycheck. While this fact is not an excuse to spend more than you earn on a monthly basis, it means that you are never in a position of trying to squeak by through delaying rent or utility payments a few days until that next paycheck arrives. The buffer of cash in a checking or savings account preempts the need.
3. Allows you to take the right job, not the first job.
Restructurings occur in the corporate world on a regular basis even during strong company or economic performance. The resulting turnover can leave even good performing employees out of a job. If certain employees’ positions are high enough and/or the company is generous, they might receive a severance payout. That payout, added to unemployment benefits can limit the damage of short-term unemployment. But what if no severance is offered? What if it takes longer than expected to find a job?
As the dates fly past, the stress of no paycheck can have a major effect on individuals and families. For many, this reality results in them taking the first job offer that they receive, even if it’s a poor option. The result could include a lower paycheck, fewer hours worked, reduced benefits, or a longer commute. An emergency fund can give a person the flexibility to continue applying for that job that is as good or better than the last one. It’s possible to turn a job loss into an increase in pay and responsibility!
4. Reduces Insurance Costs.
These days, we have insurance for everything. Car insurance, homeowner’s insurance, valuable property insurance, liability insurance, life insurance, health insurance, and the list goes on. Almost every type of insurance comes with a deductible, i.e. the portion of the loss that the policy owner has to cover. The deductible prevents the insurance company from covering trivial losses like a $50 dent repair on a car. Deductibles range from small amounts ($100 for example) to $500, $1,000, $5,000 or more depending on the type of policy.
Another way to view the deductible is as the level of self-insurance. A higher level of self-insurance results in a lower cost of insurance because the insurance company ends up only covering more significant losses. An emergency fund provides the opportunity to raise insurance deductibles across the board. Increasing the deductible on a homeowner’s insurance policy from $500 to $2,000 could save several hundred dollars per year. Raising the deductibles on multiple policies could create significant savings. The great thing about the emergency fund is that each dollar can be held to offset a deductible on more than one policy. It’s less likely that a person would have to pay deductibles for multiple policies at once. Be judicious in raising deductibles, though. For example, I keep my car comprehensive deductible at $100 because I think my highest risk is hitting an animal on the road because I live and drive through rural areas. My collision deductible is much higher.
5. Allows For Greater Investment Risk
One of the most important byproducts of a proper emergency fund is that it frees people to optimize the prudent risk in their investment portfolios to achieve future goals. Typically, that means increasing the investment allocation to stocks. A person who is confident that their emergency fund will get them through all but the worst of times can be less conservative with investments. On the flipside, the person who doesn’t have an emergency fund might have a higher allocation toward bonds which don’t build long-term wealth like stocks. For me, the emergency fund is the cornerstone for building long-term wealth precisely for this reason.
I haven’t filled this list by naming all unexpected expenses, like unplanned travel or a car break down among other things. Instead, I’ve stayed with higher level concepts supporting the use of a properly sized emergency fund. My next post will discuss how to figure out the proper value of that emergency fund. Sure, some rules of thumb exist, but I’ll add in examples of situations that might increase risk and require a more substantial emergency fund, and vice versa. Until next time…
Did you enjoy this article? If so, please sign up to receive alerts whenever I post a new article. My blog will cover a myriad of financial topics and challenges, book reviews, and commentary on current events in the financial world to benefit our military and veteran community. I attempt to be as thorough as possible when examining a subject but can never account for every possible scenario. If you’re interested in more tailored advice, please visit my website to learn about how I help our service members and veterans plan for and achieve financial independence.