Why Start an Emergency Fund?

There is nothing less sexy in personal finance than the emergency fund.

Yes, I realize that contemplating death while diving into a life insurance policy is no fun either, but I’ll save that for another day. While the emergency fund may not be the overindulgent life of the party, it is definitely the dependable friend who will get you home and safely into bed.

The hierarchy of savings is a popular topic in personal finance. Search for the phrase in Google, and you’ll see what I mean. I like to think of an emergency fund as the foundation of the saving’s pyramid. It should be the first place you save money. Yes, even before you jump on Robinhood to start trading options.

Michael Kitces included a fantastic version of the pyramid you can find in his article – “The Hierarchy Of Tax-Preferenced Savings Vehicles For High-Income Earners.” It appears below.

A colorful pyramid illustrating the hierarchy of savings

How much should I save?

The most common recommendation is to save enough to cover 3 to 6 months of expenses. Solid advice. But how do you know which number is right for you? Ask yourself the following questions.

  • How many sources of income does my family or I have?
  • How stable is my job?
  • How quickly would I be able to get another job?
  • Do I have substantial investments that are reasonably liquid outside of my emergency fund?
  • What percentage of my monthly spending is discretionary, and can it be cut in an emergency?

It can be difficult to answer some of these questions accurately but err on the side of adding an extra month or two in savings if you’re in doubt.

What makes an emergency fund so important?

There’s no better way to derail your retirement plans than to pile on some high-interest debt because you lost your job. Your emergency fund is there to provide funds when life throws an unfortunate surprise at you. 

A brown shoe about to step on a banana peel

An emergency fund also gives you options. Panic over a lost job, a medical emergency, or a car accident can result in rushed, poor decision making. If you find yourself unemployed, would you rather calmly look for a new position that fits your career goals with a company you admire or grab the first job that comes along because you’re desperate for income?

Do I have to worry about this? I make some serious coin!

Given the importance of establishing an emergency fund, it’s sad to see only 28% of people in the U.S. have savings equal to six months of expenses, according to the Federal Reserve. And before you dismiss this as a problem for Generation Z, the same survey shows that only 39% of people over 55 have savings to cover six months. But high-income earners are rock-sold, no? Not really. Only 54% of earners in the top quartile could cover expenses for half a year using emergency savings.  

What’s even worse? This survey was completed well before COVID-19. I’ll take a wild guess that savings levels are even lower now for many Americans.

Even with a high income and substantial retirement savings, an emergency fund is a good idea. Retirement savings are great – for retirement. If you have to access retirement accounts in an emergency, there may be penalties, taxes, and fees. You will also miss out on the growth those investments would have delivered, potentially setting back your retirement goals.

When should I access my emergency fund?

Uh, in an emergency? True, but try to define what this means beforehand. An emergency should be a serious, unexpected financial event that must be addressed. Medical bills, car repair, a job loss are all reasons to tap your fund.

A toy ambulance

I work with travelers, and I know the pandemic lockdown has been difficult. You might believe that a trip to Paris after you’ve received a COVID-19 vaccine is an emergency of mental health. But, no, while possibly an emergency, it’s not a good reason to tap your fund.

How to build it?

Put your emergency savings into a separate account. Setting up an automatic withdrawal from either your paycheck or a checking account is the best way to fund it. I emphasize automatic, so it happens without effort on your part. It may take time to meet your emergency fund goal, but religiously making a deposit on a set schedule works well.

Where should I put it?

Liquidity is the key. Emergency money should be saved in a place that can be accessed quickly. A high-yield savings account or a money market account is ideal, and both are insured by the FDIC up to $250,000. Don’t get cute and reach for a higher yield by putting your emergency fund into an investment product that might lose value, is not insured, or is not readily available when you need it. Also, there are many financial institutions that are competing for your business, so look for accounts that will not charge you a fee of any kind. Bankrate is an excellent resource to find the best yielding money market accounts.

How else will an emergency fund benefit me?

An exciting part of having an emergency fund, yes, I said exciting, is it gives you financial flexibility. You can use this flexibility to save some serious money. How, you ask?

Do you have a low deductible on your auto or home insurance? An emergency fund can allow you to raise the deductible and save money over the long term, assuming you’re not accident-prone.

A common question asked by travelers – Do I need travel insurance during COVID? The answer may be no if you have a hefty emergency fund, and your only possible loss is financial, measurable, and manageable.

If the possible loss can be strictly defined and equal to 10% of your emergency fund or less, I’d recommend passing on the insurance. On average, you will come out ahead financially in the long run. However, if you have a history of making claims, you have a habit of losing things, or you can’t sleep thinking about being uninsured, then buying travel insurance is a good idea.

If you do need to access your emergency fund, replenish it as soon as you can. It won’t help you much if you drained it last year and forgot to fill it back up.

Summary

Fully funding a liquid account that is to be used only for emergencies is an essential first step in financial planning. The account can reduce stress, present you with options, and save you money. Unforeseen events will happen in your life, and it’s always better to be operating from a position of financial strength and security than having to scramble around to see which long-lost relative will float you a loan. Get this foundation of financial savings right, and you’ll be on your way to retirement glory.


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    Financial Advisor David Tuzzolino

     

    David Tuzzolino, CFA, CFP®, is the Founder and CEO of PathBridge Financial, a firm that specializes in providing comprehensive financial planning and investment management services for clients that are nearing retirement and love to travel.