Planning for the Worst
A commonly heard refrain in the personal finance world is ‘Keep 3 months of living expenses in an emergency fund!’ If fact, this is heard so much it’s almost become a mantra for people taking control of their finances for the first time. Where does this ‘3’ come from? Why do you keep it? All this and more will be answered, read on…
The sole motivation for an emergency fund is to keep you afloat, financially, if you lose your job. An emergency fund is merely insurance for a tough situation. Like most forms of insurance, you will hate to use it, but you’ll be glad it’s there when you need it.
But why three months? Apparently, three months was once the average time it took to get a job. Now that’s pretty arbitrary, but a good rule of thumb. The assumption was that in three months you could have a new source of funds to replenish the cash you drew down. And how does unemployment insurance factor in? It doesn’t. Unemployment insurance is notoriously hard to get. You have to be unemployed through no fault of your own, and you don’t qualify if you are a contractor or self-employed. Yikes; there goes most of America.
What to Add…
So, you want to get started on your fund. That’s great… but now it’s time to figure out how much to add. Here’s what I would suggest…
- Calculate a single month’s fixed expenses. These are bills you can’t float… mandatory credit card payments, your mortgage, electricity, car payments, alimony, food, etc. I don’t know everything you’re paying for, but you should know!
- Fudge it a bit, say 10%. This is to ensure things don’t get too tight when the fund is nearing it’s final scheduled month.
- Multiply by the number of months you want to insure yourself.
- Diligently add to your fund. There is a discussion of what form it will take in a further section. If you can use direct deposit or some other form of automatic deposit… set that up immediately.
How Long to Plan For
It’s tough for me to generalize how long an emergency fund should last. Say that you accept that three months is approximately how long it would take you to get a job (3 should be the absolute minimum!). Start with that, and ask yourself (honestly!) the following ‘additional fudge questions.’
- Are you self-employed?
- Is your job heavily dependent on bonuses?
- Is your job in an industry currently taking hard knocks?
- Are you having doubts your position will exist in the near future?
- Have you had vivid hallucinations of yourself unemployed?
Again, you know yourself the best. In my case, I choose to double the minimum of 3 months to get 6 months. I keep 1 – 2 months of living expenses in an online savings account, and 4 months minimum in stock at a brokerage.
Where to Put It
I certainly differ from a lot of people on this topic. The most common advice given is to keep it in a liquid, easily accessible, FDIC insured, no risk whatsoever account at a bank or credit union. How would I modify that advice? Keep it in something relatively liquid and easily accessible.
My approximate ranking for places to keep it:
- Bank Savings Account
- Short term CDs (laddered less than a year, say 3, 6, 9 12 months, renew a 12 month when each matures… and keep three months in a savings account)
- A money market account. (Beware, this is scarier than 2 years ago!)
- Federal bonds.
- Bond mutual funds.
- Broad based (key!) mutual funds.
- Individual stocks.
… 99. Stock options.
… 107. Bars of gold in your closet.
… 246. Foreign Currency
Generally, you would start with one of the top ones, and additional funds would be in the lower ones. The savings account is generally the absolute best choice. Again, I use a combination of a savings account and a brokerage account (make sure its a taxable fund you can tap without penalty!) as my emergency fund. Regardless of what you choose, do it and be willing to use it.
Get Your Priorities Straight!
You’re investing in plenty of things… a 401(k), IRA, taxable brokerages, exotic life insurance plans, an HSA, antique violins, 529 plans, and whatever your life had led you to invest in. It doesn’t matter… put this at the top of the queue. If you can free up enough cash (a big if), you should continue to invest your 401(k) and ESPP to the match, then plow cash into the emergency fund. Don’t question that, it’s sacrosanct.
A Brief Look at Mortgaging Your Future
“Oh, I’ve got a 401(k),” you claim (or IRA, or whatever you’ve got that is for retirement). “I can just take a loan/hardship withdrawal/72(t) substantially equal distribution”. No, don’t do that (if you can avoid it). In the second two cases you lose the tax advantage of the money you withdraw, leaving less for when you actually retire. In the second case you get hit with a tax and penalty. In the first case, you have to pay it back if you become unemployed. And, by the way, 401(k) loans outstanding aren’t going to matter in bankruptcy. Avoid these options at all costs!
Snap to It
Enough reading, go do something now! Find yourself a savings account, dump some cash in it, and don’t touch it until you need it. You’ll be so glad you listened to me (if you need it) you’ll send me a fruit basket. Thanks in advance!