3 Mistakes That Make Your Emergency Fund Less Effective
Creating an emergency fund is foundational to enhancing your financial wellbeing. It’s so foundational, that I recommend an emergency fund for everyone. An emergency fund is cash that you set aside for those unforeseen events, like a major car repair or a medical event. Most financial professionals recommend saving 3 to 6 months of household expenses. Three to 6 months is a helpful rule of thumb but it’s important not to be too dogmatic about how much you save. What is important is that you have a meaningful amount set aside that’s relatively easy to access. To make sure your emergency fund is as effective as possible, here are three common mistakes you’ll want to avoid.
Picking an Amount Out of Thin Air
While it’s important not to be too dogmatic about how much, it is important to do meaningful analysis, with your spouse, about the appropriate amount to save. When I’m developing a financial plan, it’s common to uncover that a family has either far too little or far too much in cash. If you don’t do analysis based on your monthly needs, you can find yourself underprepared for the next bump in the road or missing out on significant growth by keeping extra cash on hand that you could be investing.
Here’s how to get clear on how much you need to save. First, determine how much it costs to keep your household running each month. For this step, focus on necessities like food, your mortgage, utilities, gas, and your vehicle. Second, consider how consistent your income and expenses are. For example, a single person who rents, only has one car, and a regular salary has much less variability regarding their income and expenses than a couple who owns a business, has kids, and owns rental properties. Once you have a clear idea of what it takes to consistently run your household, you can decide how many months’ expenses you should save. This amount isn’t random rather, it’s based on an objective assessment of your needs and likelihood of having back-to-back emergencies. For example, if it takes $8,000 a month to run your household, you should have somewhere between $24,000 and $48,000, cash, in your emergency fund.
Not Keeping Emergency Funds Separate
Frequently, when I ask folks how much they have set aside for an emergency, they have to start doing some complicated mental math. Some may be in cash at the bank, some might be in a brokerage account, and maybe there’s a bit more in their business account. This can create trouble for a couple reasons. First, it increases the odds that you’ll get out of touch with what you actually have. It’d be terrible to find out you don’t have a fully funded emergency fund after the roof starts leaking. Second, it can make it hard to get to your emergency fund quickly. The whole point of an emergency fund is to lower stress and help you stay in control when you’re experiencing an emergency. Keep it simple, set your emergency fund aside in its own designated account.
Considering Investments an Emergency Fund
Investments just aren’t great sources of emergency funds because having to sell them in a hurry can lead to taking a loss or paying unwanted taxes. It’s fairly common to hear folks say that they’d just sell a few investments if they were in a pinch but that can lead to a real headache. What if you happened to need emergency cash in March of 2009? You would have had to sell your stock at a 40% discount. If you’re thinking, “what are the odds?” Just think of how many millions of people found themselves suddenly unprepared during the great recession when they lost their jobs or found that their real estate assets were underwater. Without extra cash or the ability to borrow more, far too many people experienced deep losses and a great deal of financial strain.
Selling investments in an emergency, even when markets are up, can lead to very real losses due to taxes and lost opportunity. For example, if you were lucky enough to buy a little Apple stock in the ‘80s, you’d probably have enough financial resources to cover just about any emergency out there, but would you really want to be forced to sell a top performer like Apple, pay 15 to 20% in capital gains taxes, and miss out on future appreciation? Of course not! From a financial perspective, not to mention an emotional perspective, it’s never good to be forced to sell anything.
Just Hang on to Some Cash, Thoughtfully
Setting aside a reasonable amount of cash is not a complicated strategy for improving financial wellbeing, but it can be a tough habit to get into. For various reasons, it’s easy to convince ourselves that we don’t need much cash or, on the other hand, we need a mountain of cash to feel financially secure. A little thoughtful analysis can help us rest easier, knowing we likely have what we need for an emergency, without undermining our overall financial goals.
While spreading investments around is a great idea because diversification significantly lowers risk, the same doesn’t apply to your emergency fund. When it comes to building up an emergency fund, the simpler the better. Keep it in one secure place and whatever you do, don’t start investing with part of it. Committing to keeping your investments your investments and your cash your cash is a helpful way to protect yourself in an emergency, make the most of your investments, and enhance your overall financial wellbeing.