If you are interested in personal finance, you should probably have come across the term Emergency Fund. An emergency fund is simply some money, available directly, that you can use in case of emergency. Most people will advise you to get an emergency fund. And they will insist heavily on this subject.
It is an interesting subject since not everybody agrees on it. Some people have an emergency fund that can cover one year of expenses. And some people think you do not need one. Personally, I do not think an emergency fund is a bad thing. But you should be aware of its cost. It also has disadvantages. And you may not need an emergency fund as big as some people tell you. I think that too much people put too much emphasis on the emergency fund. In this post, we are going to see both sides of the story. We are going to see in details what an emergency fund is.
An emergency fund is nothing special. It is just a simple bank account where you store away some money that you may need for emergencies. A general rule of thumb is to store three to six months of your expenses. It is important to base that on your expenses and not on your income. But some people will save away more than one year of expense.
There is something really important about an emergency fund. If you believe that you need to have one, you should have one in a very liquid account. It does not make sense to invest your emergency in highly liquid stocks. If you need the money today, you may have to sell at a very bad price. It should be in a savings bank account.
Why you should have an emergency fund? In case of emergency, you have something to pay it.
- Imagine you have a very large medical bill coming (2500 CHF), can you pay it?
- Or if your car breaks down and you have to replace it.
- Your house is flooded and you have to pay a large bill
- Your phone breaks and you have to replace it
There are many more reasons that make people want to have an emergency fund.
In general, I believe having an emergency is a great thing. But they have a large cost. And most people do not consider this cost when they advise an emergency fund.
The cost of an emergency fund
Emergency Funds have one big problem: The opportunity cost. The simple fact of not investing this money is costing you. You could invest this money in an ETF that would give you an average 5% per year (I am being conservative). Let’s take my current emergency fund of 15000 CHF as an example. Investing it could yield me 750 CHF per year. This is a lot! And this is not taking into account compounding interest over the year. You need to be aware of this. If you have access to high yielding interest account, it may be acceptable. But we do not have anything like this in Switzerland.
If your emergency fund yields you less than inflation, you are actually losing money every year. In most countries, saving accounts have lower interest rates than inflation. This is almost always the case.
If you really want an emergency fund, there is nothing you can do about this cost. But maybe you do not need one. Or maybe you need a smaller one than you think?
There is another cost related to emergency fund: The Temptation. You may be tempted to use that money lying in your emergency account. This should not happen to frugal and responsible people. But this is something that may happen. You may think that it is a good place to take money for that brand new TV you wanted ;)
Do you really need an emergency fund?
You may not need an emergency fund as much as you think. Or at least, you may not need it to be as big as you think. There are a lot of people living very well without an emergency fund. I may get some dislikes from this section, but I think it is important to know about it :)
Of course, not having an emergency will not prevent you from having to pay for an emergency if it happens. So, how to pay if there is an emergency?
- With your credit card
- Use your next paycheck to pay it
- Sell some equities
If you have a large limit on your credit card, you can actually pay a lot of emergency bills with it. Or withdraw money to pay for them. If you are saving a large percentage of your income, you have a lot of margin to pay for emergency each month. That just means you will invest less the following month.
And a lot of risks are not as great as you think:
- If you have a health insurance, you only have to pay the deductible. 2500 CHF for me.
- If you have a car insurance, you only have to pay the deductible as well.
- If you get fired or do not find a new job after the current one, you should have unemployment insurance for several months. And unless you did something really wrong, if you get fired, you will get a severance package.
- If I die, I have got a life insurance with which my wife can live several years.
- Lots of things can be planned. For instance, it is not very difficult to estimate when you need new tires. This is something you can budget for. You should try to plan for big expenses.
As you can see, you are already protected for very large unexpected expenses. If you have a stable income, a good credit card and you save a large part of your income, you can have a small emergency fund only. Or even no emergency fund at all. Of course, if you have no insurance for anything, this may not be the same issue. You need to study the risk you are not protected against.
Of course, you should not take my word for it. Big ERN at earlyretirement.now has an emergency fund of 0$ and gives you 10 reasons why they are not good. Go Curry Cracker also mentioned that Emergency Funds are overrated. If you have a strong financial status, you may not need an emergency fund as strongly as you think.
My emergency fund
After having my research on the emergency fund, I am now realizing that my emergency fund is too big. I keep an emergency fund of 15’000 CHF. This a bit more than 3 months expenses. We are able to save up to 50% of our income each month. That means one salary is covering the expenses of two months. We can also cover about one month expenses with our credit card as well. I have a health insurance with a deductible with 2500 CHF deductible. And I have a full insurance for my car with a deductible of 1000 CHF. That reduces the risk highly.
I will reduce my emergency to 10’000 CHF in a first step. I may reduce it further later. For now, I do not want to take any rash decisions. Currently, I am transferring my second pillar to my new company pension fund. Once it is done, I may invest a lump sum into my second pillar. Or I may invest that money in my broker account. Or maybe a mix of both. I will tell you what I am going to do once I did it. I will wait until the end of this month anyway.
Emergency funds are a good tool to protect you against big emergency expenses. However, they have a big cost because that money is sleeping without bringing any interest. Generally, bank accounts interest is lower than inflation. So your emergency money is losing value every year. Moreover, you are generally more protected against big expenses.
In my opinion, an emergency fund is not a bad thing. But you should not have a too big emergency fund. If you have an income, I do not see the point in having an 8 months emergency fund. If you are able to save a large part of your salary, you are already covered for some big expenses. And of course, you need savings! Nobody advises you to have zero savings. But you should invest more of your savings.
If your financial situation is bad, the first thing you need to do it to get out of debt. Then, you need to increase your savings rate as much as possible. The emergency fund will only come after this.
Do you have an emergency fund? How many months of expenses do you keep into it?