Personal finance experts throughout the land will tell you that you need to have an emergency fund. Today I am going to discuss the reasons behind having an emergency fund and what we can do to optimize it.
The purpose of an emergency fund is to act as a risk mitigation tool.
An emergency fund is a form of self-insurance. If you need to use it you are sure glad you had it, but if you don’t need to use it you would have been better off doing something else with your money.
There are a huge number of risks people and businesses face each day that warrant keeping an extra bundle of money in a very liquid form (cash). The most commonly cited example I hear from people is that they are keeping 3 to 12 months worth of expenses in cash in case they lose their job. I think this is a great reason to keep some extra cash around to pay for everyday living expenses while you figure out where you are going next.
Too much Emergency Fund
I’ve had a few people ask me what the drawbacks of having a much bigger emergency fund is. The answer is that having extra money sitting around in the form of cash is not productive. There are far more efficient things your capital can do for you (i.e. investments) rather than sitting in a bank account collecting the minuscule interest that a bank will pay for your cash deposit.
Some of the best interest rates for bank cash deposits I have seen are currently around 1%.
Too Little Emergency Fund
Let’s say you have zero emergency fund. What happens when you need to pay an extra car repair bill you didn’t plan on? Since your car mechanic doesn’t accept homemade cookies as payment (I do) you’ll have to pay him with some form of a loan. Let’s say you use your credit card, but you aren’t able to pay the balance at the end of the month because you don’t have any leftover cash. This means you are going to be paying interest on whatever the cost of the repair is.
The average interest rate of credit cards is between 15% and 22%.
The Goldilocks Zone for Emergency Fund
The Goldilocks Zone is the amount of money where you strike a balance between your lost opportunity on the money that only makes 1% in a bank account and the amount of money you have to pay a high interest rate on because you don’t have the liquidity needed to cover expenses in an emergency.
No single answer is correct for everyone. Let’s look at some factors to consider that can help guide you towards the best decision.
- How secure is your current income? If your current company is posting great profits and you are a valuable part of that team you might consider holding a smaller emergency fund. This isn’t a set it and forget it situation though. If circumstances in your company change, you need to be aware and give yourself additional cushion.
- How easily could you find new source of income? If you have skills that are needed by many businesses you might consider again reducing your emergency fund.
- How old is your car? Your house?
- Do you have any concerns with your health or your family members’ health? How old are you? What are your health risk factors?
- Look back at your old income statements and see how often you have large unexpected spikes in expenses.
Do you have a smaller or larger emergency fund? Have you thought about why? Let me know if the comments.