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Lesson 4c: Emergency Fund

Objective: Determine how much of an emergency fund you want.

No one thinks of an emergency fund as an insurance fund, yet it is. 

An emergency fund has two purposes:

  • To provide a safety net against unexpected expenses (e.g., your furnace needing to be replaced just as your car broke down as well)
  • To cover living expenses if a wage earner loses his/her job or becomes disabled

Having an emergency fund will make it less likely for you to rely on short-term loans with high costs (e.g., credit card debit and payday loans), and will allow you to avoid selling investments prematurely if the markets are down (e.g., if you lose your job during a recession).

An emergency fund is not for:

  • Holiday presents
  • Routine repairs (e.g., car breaking down or appliance needing repair)
  • Replacing household furniture
  • Vacations

    These expenses should be planned for and covered under your budget.  If you do not plan for these items, they become emergencies and unfortunately, become a big source of credit card debt. Items like holiday expenses should be held in a separate account.  For example, instead of using the emergency fund to pay for a $500 holiday present bill in December and January, save $42 per month during the year.  This way you have $500 for your holiday presents in your checking account when you need it.

    Reason: If you use your emergency fund for routine expenses (like holiday presents), then you will not have an adequate emergency fund in February if the furnace and car breaks down at the same time.  The key is to have an emergency fund for emergencies and a separate fund for budgeted items like vacations and presents.

How much do I need in an emergency fund?

You will get different answers from different advisors.  It all depends on your situation.

  • A common first step is to build up a $1,000 fund that will help cover many unexpected items like your furnace breaking down.
  • The next step is to build up your emergency fund to cover 3 to 9 months of living expenses.  Living expenses are items in the budget that are fixed or essential (e.g., mortgage, utilities, food, etc.).  Living expenses do not include vacations.

    So should you plan for 3 months or 9 months of living expenses?  The more risk you have, the larger the emergency fund should be.  Risk can be measured by looking at the following factors:

    Lower Risk
    Higher Risk
    Paid by salary Paid by commission In general, being paid by salary provides a steadier flow of cash than being paid by commission.
    Working for a steady industry (e.g., health care) Working for a volatile industry (e.g., retail) Volatile industries are more dependent on the economy and will have more layoffs in down economies.
    Working in a field with low unemployment (e.g., nursing) Working in a field with high unemployment (e.g., manufacturing) If you lose your job but have skills in high demand, you will have an easier time finding a new job.
    Having disability insurance (short-term and long-term) Not having disability insurance If you have insurance, you have reduced your risk.
    Having an advanced degree Not having a high school degree Those with advanced degrees are in more demand and are more qualified for other careers as well.
    Dual wage earners Single wage earner With two wage earners, there is a second income if one person loses his job or becomes disabled.
    Having liquid assets to use if needed Having little or no liquid assets.  A 401(k) is not a liquid asset! If you have a vacation or educational fund, you can always tap into this if needed for an emergency.
    Being healthy Having chronic illnesses Having chronic illnesses increases your need for disability insurance and/or an emergency fund.
    Living expenses that depend on 60% to 70% of income Living expenses that depend on 100% of income If you lose your job or become disabled, disability and unemployment benefits usually only pay 50% to 80% of your previous pay.  So if you have more expenses, you need a larger emergency fund.
    Stable family Possible changes (baby or divorce) Usually the additional expenses or lose of income for these events are not planned for, even though for many, they have a good idea of the likelihood that these events may occur in their particular situation.

    The key to an emergency fund is to have cash to fund your expenses in case you lose your job or become disabled.  With an emergency fund, you are less likely to rely on high-cost alternatives such as using credit cards or payday loans, for example.  However, many do not plan for these events to happen (possibly thinking they are not even an once-in-a-lifetime event) and are then caught short when they do occur.  Remember, being disabled for 90+ days occurs to at least one in every five workers at some point in their career and the chance of being unemployed is much greater than being disabled.

How do I invest an emergency fund?

52% of employees live paycheck to paycheck including 34% of those with earnings of $75,000 or more.
2003 MetLife Study of Employee Benefits Trends

Emergency funds should be placed into separate accounts like money market accounts (to earn some interest while protecting the principal) and not in your day-to-day checking account which you may be tempted to use for day-to-day expenses.  Emergency funds should not be invested in stocks or bonds because if there is an economic downturn, the fund may have declined in value just as you need the money


Exercise: Determine the following:

    1. How large of an emergency fund do you want?
    2. How much do you already have allocated to an emergency fund?
    3. By when do you want to save the difference in (1) and (2)?  How much do you need to save per month to accomplish your goal?
Financial Topic : Planning Retirement
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