Do you need an emergency fund?
Most personal finance books promote the idea of creating an emergency fund as a fundamental step in personal finance. ( See personal finance guru Dave Ramsey and Senator Elizabeth Warren
Why? Because if you have an emergency, you can use that money instead of using your credit cards or dipping into your savings account.
COVID-19 has shown us that the world is full of surprises. No one could have predicted a pandemic of such a magnitude and global scale.
The recommended amount for an emergency fund is the equivalent of 3 to 6 months of your regular monthly expenses.
For example, a person with a $40,000 salary will have a monthly income of about $3,350.
A three-month emergency fund would be about $10,000
A six-month emergency fund would be about $20,000
That’s a lot of money.
The typical textbook recommendation is to put this emergency fund into a zero risk, liquid account, like a savings account. Usually, these kinds of accounts earn zero interest.
With the stock market’s average rate of return of 8%, that’s a huge opportunity cost. Your emergency fund is costing you a lot of money.
Paying your credit card debt should be your highest priority
The average amount of debt carried by a typical person:
Credit Card: $15,762
Mortgage: $168,614
Auto Loan $27,141
Student Loan $48,172
In a world where credit card interest rates fluctuate between 18% and 22%, it makes no sense to have $10,000 sitting in a bank account, earning 0% while holding a credit card debt of $15,762 at 18%-22% interest rate.
Paying down your credit card debt should be your highest financial priority. There should be no savings for retirement, no savings to buy a house, no nothing until your credit cards are paid. Your credit card debt is your emergency.
You should also pay off other debts, such as your mortgage debt ( about 4%), auto loan (about 6% ), and student debt ( about 6% ). Why forgo reducing these debts in order to have money sitting in a checking account earning 0%? This makes no sense.
Invest your emergency fund
Let’s suppose you have paid all your debts. Would it be a good idea to have an emergency fund now?
No!
Either the Canadian index or the US index has an average return of 8% per year. Investing money at 8% sounds a lot better than letting your money sit in a bank account earning 0%.
But what if you have an emergency?
The usual examples used by experts for an emergency fund are:
- Your car breaks down, or
- You get sick.
Car repairs don’t cost $10,000. If yours do, you are driving the wrong car and you have a consumption problem. Your problem is not lack of an emergency fund.
Most people get sick for about a week, this is not an emergency. If you have a more serious illness, $10,000 will not solve your problem. Your problem is lack of proper insurance.
Emergencies should be rare events that happen every 5 years or so. If you have an emergency every year, then it is not an emergency, it is a recurring expense.
What if you have a more serious emergency?
Credit card: Get your credit card, pay for your emergency, and then pay for your credit card debt within 30 days with alternative forms of financing.
Line-of-credit: The interest on a line of credit (right now) is about 5%-6%. It is better to have this debt at a low-interest rate than to use money in your investment account which could be earning about 8%.
Your investment account: A final alternative is to take money out of your investment account. Assuming that a real emergency happens every 5 years, your investment account had 5 years to grow at an average 8% return for 5 years. Assuming a scenario where the market drops 20% right before you need your money, you are still better off than leaving your money at a savings account earning 0%.
How do I deal with emergencies?
I don’t recall having an emergency during the past 18 years. The biggest unexpected expenses I’ve had are parking tickets.
However, I do keep a checking account with a balance that fluctuates between $5K and $10k. If it has less than $5k, I panic and find ways to increase it. If it has more than $10k, then I send more money to my investment account. As a freelancer, I don’t consider this amount of money an emergency fund. Because my income fluctuates from month to month, this is the amount of money I need in order to be able to pay my monthly expenses.
How do you deal with emergencies?
Comments
2 responses to “An emergency fund is not that important”
This is not an emergency fund. This is what I need to roll in my day to day life. I pay two mortgages, two rents, three electricity bills, three internet accounts, one cell phone, one vehicle, my trips out out town and I don’t have a regular job with regular payments. I need from 5 to 10 K to roll.
I generally agree with your characterization of emergency funds. However, you conclude by saying you keep $5k-$10k in your chequing account… which I’m assuming is roughly 3-6 months worth of expenses. How do you explain this hypocrisy?