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If you are interested in personal finance, you probably have encountered 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 see both sides of the story. We see in detail what an emergency fund is and whether you should have one.
An emergency fund is a bank account where you store some money 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 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.
Many more reasons make people want to have an emergency fund.
Being able to pay for emergencies is 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 regarding when you can withdraw the money. You 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 ensure 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 you can withdraw the money easily and for free.
If you want 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 must 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.
We can take my current emergency fund of 15000 CHF as an example. Investing it in the stock market could yield 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 losing money every year. In most countries, saving accounts have lower interest rates than inflation. This is almost always the case.
If you 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 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 in their emergency accounts. 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 becomes useless. You may well not have money on it when you need it!
Do you 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. It is a myth that everybody needs a large emergency fund.
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 and you do not have enough in your emergency fund?
- With your credit card.
- Use your next paycheck to pay it.
- Get a margin loan.
- Sell some equities.
If you have a large limit on your credit card, you can 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.
If this is enough, you have two more options. The first is to get a margin loan from your broker, based on your investment portfolio, if you have any. And then, the worst option is to sell your equities and get cash to pay for your emergencies.
And a lot of risks are not as great as you think:
- If you have health insurance, you only have to pay the deductible and retention fee. This is 3200 CHF for me.
- If you have car insurance, you only have to pay the deductible. 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 wrong, you will get a severance package if you get fired.
- If I die, I have 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 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.
Following the 4% withdrawal rule (or any other withdrawal rate) from The Trinty Study, you 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 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
We will now talk about The Poor Swiss emergency fund.
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 currently keeping it in my Neon account in Spaces to get some interest in it.
We can save up to 50% of our income each month. That means one salary covers the expenses of two months. We can also cover about two months of expenses with our credit card.
Finally, we have an extensive stock portfolio. Therefore, we could get a good margin loan from Interactive Brokers if we had to pay for an emergency, without selling stocks.
So, we decided to keep 10’000 CHF for emergencies. I am comfortable with that amount for Mrs. The Poor Swiss and me.
Advocates of small emergency funds
Of course, you should not only take my word for it.
Many people in the personal finance community are advocates of small emergency funds. There are even some people who think that they are not useful.
For instance, 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.
Another advocate of a smaller emergency fund is Mr. Money Mustache (Pete Adeney).
What is an emergency fund?
An emergency fund is an amount of money that you keep ready to pay 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 your spending. A rule of thumb is to save between three and six months of monthly expenses in your emergency fund. But, 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 account 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 much 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.
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 harms your finances.
If your financial situation is bad, the first thing you need to do is to get out of high-interest 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 six 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 funds, 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?
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