Emergency fund: Paranoid or practical?
What is an emergency fund, how big should it be, what should you use it for, and when are you just hoarding cash?
Right now, our emergency fund would cover ten months’ worth of living expenses for our entire family. This is, of course, assuming that Sarah and I are both jobless (though able to care for our children) and that I’m earning absolutely no income from The Simple Dollar. We would be able to pay our bills from our cash reserve for ten months in this situation.Skip to next paragraph
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First of all, how did I build that up? The truth of the matter is that Sarah and I are both pretty frugal. Our only outstanding debt at this point is our mortgage and we minimize our spending in other areas. Over the course of running The Simple Dollar, we’ve done a lot of little things to reduce our spending, from air sealing our home to putting in a programmable thermostat and mastering the use of our kitchen. Beyond that, we’ve both reached a point where our frivolous spending is pretty small. I would not be surprised if I spent less than $100 out of pocket on things that aren’t basic requirements in 2011. Truly, I don’t feel like I need anything, and my wants are pretty minor as well. When you don’t spend, you accumulate.
(It’s also a sign that “ten months’ worth of living expenses” isn’t nearly as much money as you might think it is. It covers our mortgage, our bills, and about $350 a month for food.)
Here’s the thing, though. A great deal of that accumulation is just sitting there in cash form. Rather than putting a significant portion of it into investments, I keep it for an overly large emergency fund.
Is that a good thing (better safe than sorry) or a bad thing (being too overcautious is keeping me from reaping rewards)? Well, let’s walk through that question step by step.
What’s an Emergency Fund?
Simply put, an emergency fund is some amount of cash you have in reserve to handle life emergencies. If you lose your job, your emergency fund is there to help with the bills. If your car’s transmission starts dragging on the ground, your emergency fund helps with the repair bill. If your sister shows up on your doorstep in tears and you find yourself with an unexpected house guest to feed and clothe for a month, your emergency fund is there for you.
You get the idea.
An emergency fund should be relatively easy to access. For some people, just having it in their local bank’s checking or savings account works. For others, it needs to be in a more remote location, or else temptation will convince them to spend it all on bubble gum.
An emergency fund should not be a credit card or a line of credit. Both of these things rely on a bank that’s always going to be willing to extend credit to you. The very time you need an emergency fund is often the very time you become a less reliable place to extend credit to. Credit cards and lines of credit are not rock-solid and reliable.
In short, an emergency fund needs to be reliable and accessible to truly be useful.
How Big Should It Be?
This is really the big question, isn’t it?
Dave Ramsey, for example, suggests that a person shouldn’t have an emergency fund at all until they’re caught up on their bills and shouldn’t have more than $1,000 in their emergency fund if they have any outstanding high-interest debt (probably anything above 8% or so).
The more personal finance books you read, the more answers you get. $2,500 will be the advice from one book. One month of living expenses, says another book.
The advice I’ve come to trust and rely on is two months’ worth of living expenses for each dependent in your household. I think this is a great number to shoot for in a small household – a single person, a couple, or a couple with child.
But when you start having multiple children – as we do – does it cross some sort of line?
The Fine Line Between Practicality and Paranoia
What sort of future am I envisioning in which ten months’ of living expenses will be needed? Can I even envision emergencies that will require such a chunk of cash?
I certainly can. I can imagine a long period of unemployment. I can imagine various disabilities and long-term illnesses.
In each of these scenarios, however, I still can’t realistically conceive of how ten months’ worth of emergency fund will be needed.
The only possible scenarios where such a large emergency fund would be needed are ones that involve a long series of simultaneous incidents. Frankly, these types of scenarios border on paranoia when I step back and look at them realistically.
Thus, I’ve decided to pare down my emergency fund to six months’ worth of living expenses and put the rest into our investment account, which is being used to save for a piece of land in the country (although, of course, it might be used in other emergencies if absolutely needed).
Being practical and having an emergency fund is a good thing. Being paranoid and having an excessive cash emergency fund merely means that you’re leaving other opportunities on the table.
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