Rainy Day, Rainy Month or Rainy Year

Rainy Day, Rainy Month or Rainy Year

Rainy Day, Rainy Month or Rainy Year

Hi folks! Welcome to The Green Swan. Today we are going to chat a bit about emergency funds and, specifically, one of the major points of contention I have with them. I would even go so far as to call it an Emergency Fund Myth! What is it, you ask? The myth is the common guidance to set aside three to six months of living expenses (yes, I’m looking at you Dave Ramsey…). When establishing an emergency fund, what it comes down to is determining what exactly you are insuring for and if there are better alternatives.

Why Dave Ramsey is Wrong

Let me start by saying that Dave Ramsey isn’t entirely wrong on this topic. He makes a good point that the amount depends on your individual circumstances. For example, if you are in a two-income household then the lower end of the range may be appropriate. But if you are a single-income household or don’t have predictable income (e.g. paid on commission) then the higher end of the range may be advisable. That is what Dave Ramsey suggests and I think the consideration of the stability of your income is important to factor into your comfort level of how much liquidity to maintain in your emergency fund.

However, the premise that three months should be set aside for a two-income household still seems extreme. For a typical middle-class household, monthly expenses may amount to $4k-$5k (this is a bit of a SWAG, but it gets us in the right ballpark). I can say that my household is a bit north of this when including the mortgage, a kid in daycare, our car payment, and other normal living expenses. But based on the SWAG, Dave Ramsey would be suggesting an account set aside with $12k-$15k! Hold on…my jaw just hit the ground…yes $12k-$15k!

No way, Dave! What’s next, stock away canned vegetables and wait for the apocalypse?

My Emergency Fund

Right now you may be wondering how much money I keep liquid (i.e. checking or savings account). Well, it fluctuates weekly based primarily on the timing of paychecks and my monthly credit card payment and mortgage, but my target is approximately $3k. This amounts to just over about 50%-60% of an average month-worth of expenses, or about two to three weeks.

No, I’m not joking, and no, I’m not crazy (well, not clinically diagnosed anyway…).

Why 3+ Months!

Here are some of the common reasons an emergency fund is suggested:

  • Job loss
  • Medical Expenses
  • Home Repair
  • Car Repair

Let’s tackle these one by one.

Job Loss

Yes, job loss is the most common and, to me, important reason to maintaining an emergency fund. But I still think three months is overkill. Why? First off, if you are laid off from your job, you will be able to claim unemployment benefits. Depending on your employer and job function, you may also be given a severance package. While unemployment benefits vary state by state, it typically offers 40%-50% income replacement for a standard of six months. That is pretty good if you ask me, especially since your expenses presumably do not amount to 100% of your previous income and you can presumably temporarily rely more on your spouses’ income.

If you are laid off, go out and get another job as soon as possible. Even if that means you are “underemployed” for a period of time, you would at least be bringing in some money once again. According to survey by Money, the average length of time to find a new job is just over 6 weeks (or 43 days). Even if in a so-called “worst case” where it took 6 months, rather than 6 weeks, to find a new job, and you were collecting about 50% of your previous income from unemployment benefits, you will still have excess cash in your three month emergency fund. This begs the question if in a “worst case” scenario you wouldn’t utilize your entire emergency fund, why retain such a huge amount in cash?

Medical Expenses

Medical expenses can very easily pop up out of nowhere and put a dent into a budget. But does that mean you need to set aside $12k-$15k? NO! Assuming you have health insurance that is. Yes, you will have some out of pocket costs, but it likely will be more manageable. Most folks these days have high deductible health plans, meaning the first dollar of medical expense comes from your wallet/purse. But according to the annual Kaiser Family Foundation Survey of Health Benefits, the average deductible for an individual in 2015 was just over $1.3K. Yes, that would be a hard pill to swallow (sorry for the pun), but not something that would call for a massive emergency fund.

Plus, let’s keep in mind that if you did incur a large medical expense, you don’t have to pay for it immediately. Typically the bill will come a month later, and the bill may not actually be due for another month, and if you pay with a credit card, you won’t have to pay that off in full for maybe another month. That gives you plenty of time to save some more money before you actually pay the bill with cash from your emergency fund.

An alternative to using your emergency fund for medical expenses would be a Health Savings Account (H.S.A.) which are commonly paired with high deductible health plans. Pre-tax dollars can often be set aside in an H.S.A., with investment options available including stock and bond mutual funds, and easily available to pay for medical claims.

What if you have an illness that keeps you from going back to work? Many employers over short term disability insurance, but even if your employer doesn’t this can be purchased (have you ever seen the Aflac commercials with the duck…?).

As with everything in life, it is important to review your options and not just default to conventional wisdom. If you are adequately insured, or at least understand the risks of being under-insured or “self-insured”, then a large emergency fund may not be completely necessary.

Home Repair

Rainy Day, Rainy Month or Rainy Year
Our solar panels, sitting on a new roof.

If you are a homeowner, then you know the “joys” of being a homeowner. That means random projects and repairs…constantly. But does that mean you need a massive emergency fund? NO! One alternative to an emergency fund is a home warranty insurance plan which helps with surprise expenses. This may cost a $100-$200 per year which isn’t too bad.

I’m not a big fan of insurance generally, and definitely not a proponent of home warranty insurance as it seems like more often than not there is a hole in the policy and the insurance company finds an “out” to avoid paying the claim. That has been my personal experience anyway.

But putting that aside, some of the big home repair expenses you may incur could be replacing the roof, water heater, furnace, or A/C unit. And I think the only reason you would need a $12k-$15k emergency fund would be if all four went out at the same time! A roof costs about $5-6k, water heater may cost $1k, furnace around $3k, and an A/C unit may be $4k. While I note these are approximate costs which vary by geography, size of home, and other considerations, but also serve as a good SWAG.

Plus, again, repairing/replacing big items like these for your house doesn’t mean you have to pay cash from your emergency fund on day one. Many times you could cheaply finance these purchases, or the bill may not come due for a month or so. All of which could give you time to build more cash to pay in full.

Again, it is important to review options and opportunity costs. Defaulting to the conventional wisdom of retaining a large cash emergency fund may not be necessary for everyone.

Car Repair

Rainy Day, Rainy Month or Rainy Year
Our New Pathfinder! No surprise maintenance yet!

Another major cost that can jump out of nowhere is a surprise car repair. Now granted, if you have an aging car, you can expect more frequent repairs and maintain more cushion in your emergency fund. For the sake of sounding like a broken record, does that mean you need a massive emergency fund? NO! According to AAA, the 2015 average maintenance cost per year for an average sedan is 5.11 cents per mile, or $766.50 per year assuming 15,000 miles driven.

This would be a big expense when sprung on you all of a sudden, but not something that needs to break the bank. And don’t forget, this can be put on the credit card and paid off in full a month later, delaying the time when cash is paid from the emergency fund.

If the unfortunate situation arises where you have an at-fault car accident, which can potentially result in significant and numerous financial considerations, this may not materially necessarily be a job for the emergency fund. This ideally would be a job for your insurance company with the deductible being the primary out of pocket cost.

Detailed below are my considerations:

  • Job loss is number one for us. Although we both have stable incomes, we both receive bonuses as a material part of our overall compensation. We don’t rely on this income though and know that it is at our employers’ discretion. Also, we both feel very secure in our jobs for various reasons, and are comfortable knowing we won’t be laid off in the foreseeable future.
  • Medical expenses can surprise anyone, even if they are generally healthy individuals. We have an H.S.A. account that would help us in case of a medical emergency as well as good health insurance coverage. Additionally, we both have short term disability provided by our employers. Our H.S.A. isn’t just sitting idle though, we have it entirely invested in the stock market.
  • Home repair is not a big consideration for us necessarily. We just replaced our roof last year (before installing solar panels) and our A/C units are new. We may need to replace the water heater and furnace in the near term.
  • Car repair isn’t a major concern either. Our one car is new, and the other, although about 10 years old, has only 80,000 miles on it and runs well.

Rainy Day, Rainy Month or Rainy Year Fund?

With all that said, do you need a rainy day, rainy month, or rainy year fund? Everyone’s approach here will depend on individual circumstances and comfort level. And it depends on how big of a fortress you want and the opportunity cost associated with maintaining extra liquidity (rather than investing in the stock market, etc).

That is right, there are alternatives to Dave Ramsey’s recommendation to retain your emergency fund in a separate cash account. That means factoring in opportunity costs is a major consideration. I plan on delving into this in further detail in a follow-up post next week so stay tuned.

Finally, I would suggest not thinking of it as a time period of expenses you need to cover (e.g. 3 months’ worth) and instead a flat dollar amount of cushion you want to maintain. For me, maintaining no less than $3k suffices based on my main considerations above, our insurance deductibles, etc. My wife and I have run our lives with this much cushion for ten years now and it has never failed us.

There is definitely more to discuss when it comes to emergency funds, but this is getting long so let’s put a pin in it there. For more, check out my emergency fund alternatives.

Tell me about your emergency fund. Do you have a target amount of liquidity you maintain? Is it based on months of expenses or potential major cost factors? Has your emergency fund ever fallen short and if so, how did you handle it?

Thanks for taking a look!

The Green Swan

Work Harder, Work Smarter, Retire Earlier and Find Your Beach

 

Products that may help you on your financial journey:

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Motif Investing – Low cost investment accounts

 

Disclaimer: This post is for informational purposes only and should not be construed as a recommendation or advice. Please reference my disclosure page for more information.

 

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Martin - Get FIRE'd asap

Green Swan, i keep $1000 in my emergency fund. No more than that. I can’t see the point in wasting good investing fundds in a low interest on call account when they can be working hard for me earning a decent return.

If the crap hit the fan and i need more, I can withdraw funds from other accounts within a few days. Reluctantly of course..

I understand what you mean about everyone having different circumstances but to keep 5 or 6 months on call like that is not a wise use of valuable funds.

Vicki@Make Smarter Decisions

We keep about the same amount as you mentioned ($3K depending on the time of month) and I agree with everything you say here – because of our situation. That definitely makes the difference. We have no debt and my husband gets a pension. I work part-time now and we have rental property. If I had to – I would go substitute teach or get another part-time job (and gasp…I could get a science teaching job very easily with my experience) but that would be a last resort. We already have a “back-up” plan if there would be a major illness – downsize houses (into a small SFH we own). We also have a full home-equity loan we could tap if needed (at 4%).

Apathy Ends

Agree with ya Mr Swan, 3 months is even to much for us, worst case scenario is we tap our brokerage account since its liquid and we can get the cash in 10 days if we really need it.

I do keep more than you but it is under 2 months of expenses if you count student loan payments (shooting for about 10K)

JW

A brokerage account is a great option and much better alternative. Glad to hear you’re putting your money to work. Thanks for sharing, Mr AE.

Mr. PIE

5 months of expenses is currently in cash.
Ready to deploy as and when for any number of events either home, family or market related.

When we hit FIRE in two years, we expect that will increase to cover at least three years of living expenses. You don’t want to be selling equities in a bear market which can actually extend beyond that time frame if you look at history over last few decades. If it does, we will be then ready to sell bonds once cash has been depleted.

Our stock/bond allocation at FIRE will be 65:35 reflecting age, risk tolerance and importantly protection of assets. We don’t need to be pursuing significant growth then.

JW

That’s good to know, appreciate you sharing. I’m not as close to FIRE as you are so it’s interesting to hear your approach to having comfort and piece of mind.

Three years of safe, liquid assets in retirement doesn’t seem out of bounds. Especially since your investment portfolio will still have an emphasis on stocks.

Ms Susty Themes

Right on – that’s exactly how I’m approaching it now that I’m FIRE’d. At this stage I don’t really think of it as an emergency fund, but as a safety net now that I’m drawing down funds and could be greatly impacted by a crash. Some is in very liquid savings, but most is invested in 5 yr CDs (earning about 2%), and I can get at it quickly if I really need it. Sleeping soundly…but everyone’s different.

Stefan - The Millennial Budget

Really glad you posted this as I share the same logic. Three to six months is far more than the average person needs and is very ineffective at growing wealth. As you stated throughout the post, majority of bills are not due at that moment. Even if they are you can float the bill on your credit card to buy you a few extra weeks to pay the bill. I personally do not even think healthcare should be a concern, if you have health insurance, as an HSA can cover these cost (Unless you are trying to pay with after tax dollars to get that additional gain).

From what I see with these groups of followers who follow Dave Ramsey for example, they religiously worship what he says as they either do not know better or don’t want to research any other methods. He is only good for debt but everything outside of that I have some disagreements.

JW

Good feedback, Stefan, thanks. Great minds think alike, huh? 🙂

I’ve always heard buzz about Dave Ramsey but never really got into following him.

Thanks for the comment!

Dollar engineer

Another point is if something like job loss occurs I think most people could effectively cut down their monthly expenses by a good amount. For example less eating out, no Netflix and other monthly services. Just spending less in general and tightening the budget is a possibility.

FinanceSuperhero

I’m glad you wrote about this subject, JW, as it is something I think about often. I’ll be the first to admit that I am a Dave Ramsey fan in many respects, yet I don’t necessarily agree with everything he says. In my mind, there is no better teacher when it comes to sacrificing to get out of debt, but beyond that, his teachings don’t necessarily work for everyone.

My wife and I were sitting on a rather large emergency fund about 6 months ago, and we decided to take out a portion of the money and sacrifice other spending for two months in order to eliminate my grad school debt. It was tough to pull the trigger, emotionally-speaking, because I loved looking at my savings account and seeing $15k sitting there, waiting to cover any emergency that could arise.

However, a few months later, I feel totally comfortable with $4k liquid in a savings account. Like you, I’m unconcerned about “small emergencies” because I know that we can cash flow them most months (we don’t have massive incomes as teachers, obviously, but they’re competitive for our area, and besides, we don’t really need much to live on each month). Also, I’m comfortable with floating a sizeable, unexpected expense on my credit card and paying off the balance at no interest, if need be.

And congrats, by the way, on the Financial Samurai feature. 🙂

JW

Sounds like a fair approach, utilizing Dave’s advice when it’s applicable to you but challenging advice that may not fit.

I think a lot of it is just having comfort with a smaller amount, and over time realizing it’s all you really need. Glad you made that move, putting the cash to work to get out of debt!

Thanks Finance Superhero! I appreciate you giving it a read and glad you enjoyed it.

Kate

About 2 years ago, I had over a year’s worth of expenses in a savings account. I decided to use most of it to pay off the remainder of my mortgage and I now keep about $5k in a savings account. This is mainly to cover deductibles and a few appliances or surprise repairs.

I have a brokerage account that I could easily access and it’s enough to cover a few years of expenses at this point in time. And if things got really dire, I’d tap into my Roth contributions. My main concern would be layoffs but unemployment would probably cover my expenses since I live off less than 50% of my gross salary.

What’s weird is that I bought my house at 24 with no down payment and nothing in savings, yet it didn’t worry me and I got by just fine. Must be the aspect of getting older and knowing what can go wrong that makes us want to hoard cash unnecessarily.

JW

Nice move! Sounds like you have a great plan in place if an emergency strikes, well done and thanks for sharing.

I agree, I’ve noticed a number occasions where my view on a finance matter has evolved with age (and wisdom of course 🙂 ).

Physician on FIRE

I like to keep enough cash in savings / checking to cover a typical credit card bill, which is a 4-figure amount that varies from month to month.

Beyond that, I’ve got about 15 years worth of expenses in a taxable account. That money can be in my account in 2 business days, if I’m willing to take the capital gains hit. If there’s an emergency that can’t be handled with that, I don’t want it to happen to me.

Kelsey @ Tealmama

Hello! You’ve given me a lot to think about here. 🙂 We keep a sizeable flat amount in our emergency fund. But I think we also have good reason. My husband has worked on commission for the last five years + being at the start of building my work from home income – there is a lot of uncertainty. However, we’re slowly decreasing that amount. Looking forward to next week’s post on alternatives.

JW

Yeah that’s understandable, I’d totally expect with your circumstances that you’d want a bit more of a safety net. Thanks for sharing, Kelsey.

Chris @ Sleepy Capital

Currently I like to think of my emergency fund as one month’s expenses. Although, I’m saving to eventually acquire some real estate in the future so my cash buffer is large at the moment as a percentage of assets. i should be able to weather a storm handily. Perhaps after that initial cash outlay in the next few years. This post definitely got me thinking though as to how much I just be allocating in the future!

Jim @ Route To Retire

I actually like to build up my savings, but ours serves multiple purposes. It’s comforting to have it in there in case of emergencies, but it’s mainly for real estate. For the rental properties we have, I like to have a little bit of a buffer. It also gives us the ability to have down payment money on hand to be able to jump on new rental properties when we find them.

We had about $40 in cash, but we used the majority of it as a down payment on a duplex we purchased at the beginning of the year. Right now we have about $20k that I’m continuing to add to. We’ll start shopping for another property probably later this year.

So I guess it really depends on your situation. For the majority though, I do agree that 3-6 months is overkill.

— Jim

JW

Thanks for sharing your situation, Jim. It’s kind of nice you can use that cash in case of emergency, but also as your method to make down payments on real estate investments. I suppose that buffer would also come in handy for routine maintenance and repairs on all the various real estate investments you own.

Frugal Familia

Wow reading this post and comments, I feel like an ultra-conservative. I like to keep at least 10k in cash for an emergency. For me it’s about peace of mind, 2-3 weeks reserve funds would just be way to stressful for me and I would constantly be thinking about it. I also keep another cash account which is for a potential real estate investment; if I ever find one. Been looking for almost 2 years now. As much as it pains me to only be earning 0.75% interest, I know the minute I invest the money elsewhere is when I will need it!

JW

It’s good to have a differing viewpoint and I’m sure you’re not the only way!

Best of luck on your real estate search. That’s quite a long process, why do you think you’re having trouble finding a viable property? Hopefully you’ll be able to put that money to use soon.

Thanks for sharing!

Debt Hater

I actually have around 6 months in expenses saved up, and I always tell myself that I’m being “too careful” because I know if I was unemployed or had unforeseen medical expenses (probably the ones hardest to recover from and most costly) I would probably also be cutting down on my regular expenses. There would be less driving, no eating out, and less money being used for “fun money’ at that point. Your article has made me once again revisit those thoughts to invest some of that money elsewhere instead!

JW

I’m glad I’ve helped you take a closer look at your emergency cash needs. I think next week’s article will help you examine it more closely as well. Thanks for stopping by!

earlyretirementnow

Very important topic for the FIRE crowd! Our entire investment portfolio is our emergency fund. Apart from $1,000 in a checking account, a few 100 dollars in a safe place at home and probably another 20 between the sofa cushions we found it most efficient to invest the large chunk of FIRE savings in productive assets rather than cash earning negative real interest rates.

JW

Thanks ERN! That’s definitely a very efficient system you have there.

If you ever decide to replace that couch, I’ll take it off your hands for you 🙂

Dividend Diplomats

We keep a few months liquid. A year would probably be too much for us. one thing that helps me sleep at night is that I know that in a true emergency I can always liquidate the stocks in a non-retirement account. That is my last resort option, but I know it is there if needed. so I tend to run lean on cash, push as much into investments as possible, and get my dividend income growing as fast as possible.
b
I like how you have thought out your plan and have a great strategy/explanation for WHY you save the amount liquid that you do. Emergency funds are extremely important. The worst thing to me is having a panic or worry at night because your don’t have cash lying around when needed.

Thanks for the great read!

Bert

Mel @ brokeGIRLrich

I agree comfort level really factors in here. Personally, I’m just more comfortable with a higher liquid amount because of the unreliable nature of my job. I like it to have 6 full months of expenses and my health insurance and car insurance deductible in it – so around $10,000. The personal finance blogger in me realizes there are definitely better ways to let that money grow, but just me being me – to sleep comfortably at night – need my emergency fund to hang out around that number.

JW

Thanks for sharing, Mel. You must keep your expenses really low if 6 months amounts to $10k! Good for you. Hopefully you’ll enjoy the follow up post on emergency funds and see if there are any feasible alternatives for you. Thanks for sharing!

Mr. SSC

We seem really conservative after reading these comments. Mrs. SSC and I debated this a lot, expecially when we first got these accounts set up. We stay at about 3 months of expenses, but with the recent downturn in our industry and the very real prospect we could both be out of work, we bumped it up substantially. So our “emergency fund” now has 2.5 months of expenses, while our “layoff fund” has closer to 6 months of expenses in it.

We were going to add it back in to the general pot and draw it down some, but it worked out nicely because there is a good buffer for Mrs. SSC not getting paid until October, now that she’s at her new gig.

She’s a fan of having a lot tighter/lower amount in the emergency fund whereas I feel more comfortable having the cash around. Also, seeing that if we both got let go, we’d be liquidating assets in a down amrket which would suck because it would amplify the loss. Or at least it feels that way.

JW

Yeah that makes sense. Perhaps you’ll be able to wind it down a bit closer to October when she starts.

Fortunately the market hasn’t been too bad lately, but I do understand that risk of potentially liquidating after a downturn. My thought had been that in time the growth it provides will help offset that risk compared to the opportunity cost if it sitting idle.

Thanks so much for sharing!

Dividends Down Under

Hey JW,

Nice thoughts and summary, I get your points. I don’t think there’s any ‘one’ answer and I think that everyone should hold a decent amount of cash (job loss, recession, for investing opportunities), it doesn’t have to just have the label ’emergency fund’.

I think it also depends on circumstances – I’d advocate more (%wise) of an emergency fund for people like us (young, 1 income family, low assets)) than yourselves (who’ve made it over the $1M mark, can sell assets if necessary and have many additional sources of income). Of course everyone SHOULD aim to get into a financial position like yours, but until then.

We are currently sitting on a large amount of cash as we’re saving for IVF and currently also have a 3 month’s expenses’ emergency fund (which amounts to $6K in total, which isn’t that much in absolute terms of money).

In the future we’ll have a cash-ready-to-invest fund when the market dips.

Tristan

JW

I can understand your view and logic behind it as well. And I don’t disagree with having a larger buffer given your circumstances and IVF efforts. I think the next step of the discussion is viable alternatives and opportunity costs which I’ll get into with my next post. I’ll be interested in your thoughts. Thanks Tristan!

NZ Muse

Job loss is my biggest concern – how it works here is if you have a working partner you basically qualify for zilch in benefits. Hence private income protection insurance. Which in turn has had me thinking about how much I realistically need in an EF. It would be nice to have 3 months in terms of the feelgood/peace of mind.

JW

Oh wow, I didn’t know that’s how they do it in NZ. Interesting! It would be tough to get by on just one paycheck unless you can go very frugal and cut out a lot of expenses. Thanks for sharing!

ambertree

Hey Green Swan,

This offers an interesting perspective on the need for an emergency fund. Ours is north of the number of months you quote… I know, it drags down our results. Give us some time, I am sure we will reduce the cash we hold. Some things take time…

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