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If you are interested in personal finance, you probably have come across the concept of emergency funds. An emergency fund is simply some money available directly that you can use for emergencies. Most people will advise you to get such an account. And they will insist heavily on this subject.
It is an interesting subject since not everybody agrees on the importance of the emergency fund. Some people have an emergency fund that can cover one year of expenses. And some people think you do not need one.
An emergency fund is a good 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. Too many people put too much emphasis on their emergency funds.
In this article, we are going to see both sides of the story. We are going to see in detail what an emergency fund is and whether you should have one or not.
An emergency fund is a 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. But some people will save away more than one year of expense. We will explore below how much you should have in your emergency fund.
It is important to base your emergency fund on your expenses and not on your income. You are not spending your income! Or at least, you should not!
Reasons for having an emergency fund
Why should you have an emergency fund? In case of an emergency, you have money available to pay for it.
Here are a few examples:
- Imagine you have a huge 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.
Being able to pay for emergencies is really the first level of personal finance. This should be your priority. But these funds have a high cost. And most people do not consider this cost when they advise an emergency fund. We will cover this fund in this article as well.
Where should you keep your emergency fund?
You should have your emergency fund in a very liquid account.
It does not make sense to invest your emergency fund in highly liquid stocks. If you need the money today, you may have to sell at a terrible price. It should be in a savings bank account.
Ideally, you want to save the money in a high-interest bank account. However, sometimes this is not possible. For instance, some bank accounts have limitations as to when you can withdraw the money. You really want this money to be available instantly.
And in some countries, bank accounts have no interest rates, like in Switzerland these last years. In this case, you can keep it in your salary bank account. This makes it very easy. This is what we are doing.
If you feel like you need a separate bank account, feel free to separate it. Just make sure you are not paying any fees to store your emergency money!
Some people save their emergency fund in a money-market account. If you have a good account like this available, it may be a good option. They generally have higher yields. But you need to make sure that you can withdraw the money easily and for free.
If you want to find a free bank account for your emergency fund, read my article about the best banks in Switzerland.
The cost of an emergency fund
Most people never consider the downsides of an emergency fund. There are several disadvantages to having an emergency fund. You will need to balance these disadvantages to know how big of a fund you need.
The opportunity cost
Emergency Funds have one big problem: The opportunity cost.
The simple fact of not investing this money costs you. Opportunity costs are something that many people never consider. But it is an essential concept.
Instead of having this money in a savings account, you could invest it in an ETF that would give you an average of 5% per year (and I am conservative). So you are losing out on these returns.
Let’s take my current emergency fund of 15000 CHF as an example. Investing it in the stock market could yield me 750 CHF per year. This is a lot! And this is not taking into account compounding interest over the years.
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 savings account yields 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?
The distraction factor
Many people do not realize that having a large emergency fund will distract you from your other financial goals.
If you set yourself to save one year of expenses for emergencies, you will need quite some time to do it. For most people, this will probably take a few years. This means that during this time, you will have no money to work on your other goals.
Having a smaller fund would let you work on your other goals as well. For instance, this could let you reduce your debts. Or you could save money towards a down payment on a house.
The temptation factor
There is another cost related to emergency funds: The Temptation.
Some people may be tempted to use the money lying in their emergency account. This should not happen to frugal and responsible people. But this is something that may happen. You may think it is a good place to take money for that brand new TV you wanted!
If you start taking money out of this fund without an emergency, it really becomes useless. You may well not have money on it when you need it!
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 one.
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 many emergency bills with it. Or withdraw money to pay for them. If you are saving a large percentage of your income, you have a large part of your salary to pay for emergencies 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 health insurance, you only have to pay the deductible. This is only 2500 CHF for me.
- If you have car insurance, you only have to pay the deductible as well. This is 1000 CHF for me at maximum.
- If you get fired or do not find a new job after the current one, you should receive unemployment benefits for several months. And unless you did something really wrong, you will get a severance package if you get fired.
- If I die, I have got life insurance with which my wife can live for 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. For a lot of people, emergencies could be avoided with better budgeting.
As you can see, you are already protected from substantial 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. 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 risks you are not protected against.
Saying that everybody needs three to six months of expenses in cash is just dumb.
Of course, this will highly depend on your situation. Some people have more risks than others to lose their jobs. And this can also depend from one country to another. This is why you need to assess your own situation.
Moreover, if you know that you are not good at managing money and keeping on budget, you should probably have an emergency fund. But once again, this will depend on each situation.
Emergency funds in retirement
In retirement, things will be very different.
If you follow the 4% withdrawal rule (or any other withdrawal rate) from The Trinty Study, you will live from your withdrawals. You have two choices for this: monthly withdrawals or yearly withdrawals.
Generally, monthly withdrawals are a bit better in the long-term. But yearly withdrawals are easier to manage.
If you opt for monthly withdrawals, you will only have one month of expenses in cash ready to be used. In that case, you may want to use a second account for your emergencies.
With yearly withdrawals, you do not really need an emergency fund. You already have one year of expenses in a cash account. If there is an emergency, this will mean that you will have to sell shares earlier than intended.
Our emergency fund strategy
Let’s now talk about The Poor Swiss emergency fund.
Once I did this research originally, I had an emergency fund of 15’000 CHF. At that time, this was more than three months of expenses. But I realized that this was too much. Given my safe situation, I decided to lower it.
Now, we keep an emergency fund of 10’000 CHF. This is a bit less than two months of expenses. This is more than enough for us. I am simply keeping it in my main bank account. It is simpler like this. And bank accounts in Switzerland do not currently yield any interest.
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 two months of expenses with our credit card as well. I have health insurance with a deductible with a 2500 CHF deductible. That highly reduces the risk.
So, we decided to keep 10’000 CHF for emergencies. I am really comfortable with that amount for both Mrs. The Poor Swiss and me.
Advocates of small emergency funds
Of course, you should not only take my word for it.
There are many people in the personal finance community that are advocates of small emergency funds. There are even some people that think that they are not useful.
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.
Another advocate of a smaller emergency fund is Mr. Money Mustache (Pete Adeney). You can watch this video by Pete to learn more about his point of view:
What is an emergency fund?
An emergency fund is an amount of money that you keep ready for paying for emergencies. It should be accessible very quickly, probably in a savings account.
How much should be in an emergency fund?
How much you need in an emergency fund depends on how much you spend. You could save three months of monthly expenses in your emergency fund. It will also depend on how safe your job is and your risk aversion level.
Should everyone have an emergency fund?
Not necessarily. People who have a stable job and have access to a good credit line do not need an emergency fund. And most people do not need an emergency fund as big as people believe.
Emergency funds are a good tool to protect you against big emergency expenses. However, they have a high 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 than you think.
In my opinion, you should not have too big of an emergency fund. If you have an income, having eight months of expenses saved is not necessary at all. If you can 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 most of your savings.
I think that everybody should have a small emergency fund of at least one month of expenses. But having more may not be as necessary as other people would tell you. And having a huge reserve is actually doing more harm than good to your finances.
If your financial situation is bad, the first thing you need to do is 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. And once you start saving more money, it will come naturally.
Now, as always, it is important to find the solution that works for you. If you cannot sleep without 6 months of expenses in your bank account, just do it and do not let anybody tell you it is bad! And if you can sleep with zero emergency fund, do the same!
To learn about another kind of fund, you can read my article about the opportunity fund.
Do you have an emergency fund? How many months of expenses do you keep into it?