Do you need an Emergency Fund?
This is a hotly debated topic in the finance community. A lot of it depends on where you are in your financial journey. An Emergency fund is typically thought of as 3-6 months of expenditures in an easily accessible account. The reason people advocate for an emergency fund is for protection. There are typically two types of Emergencies; the first is a life event and the second is the fixing or replacing of material object. A life event would be job loss, death of a spouse, medical bills, or even a job change. Replacing or fixing a material object would be unexpected expenses such as car repairs, your air conditioner or furnace goes out. This is typically something that you can not pay for in one month. The question now is, how do you protect yourself from these events? That way when they do occur, you can minimize stress.
As an example, we calculate we have $4,000 of expenses to cover each month. By the standard theory of 3-6 months, we would need to tie up $12,000-$16,000 dollars of our money in a savings account. Typical savings account is 1% interest or less. Over a ten year period that money compounded with a 1% interest rate would be $17,682. The good news is you are not losing money. The bad news, that money is not doing much work for you. Some people prefer stashing money in savings account. Having money so easily accessible provides comfort for them. If you are just starting your financial journey and have very little money overall, including investments, having a little money in a savings account is not a bad thing. Once you have built some wealth, having $16,000 in a savings account might not be necessary.
Still using $16,000, lets now keep only $4,000 in the savings and invest the $12,000. In ten years we will have about $4,420 in our savings and using an interest rate of 10% on the investment account we will have about $32,484 in the investment account. That is how you make your money work for you. Another factor to consider is that while you are saving the $16,000 just in a savings account you could be missing out on gains in the market. Some people will freak out at only having $4,000 in a savings account. The thing most people don’t consider is there are very few emergencies that you are going to need $4,000 right now and there. Credit cards can be very beneficially. Not only can get points, but you can buy yourself a month to get the payment completed. I do not advocate taking on credit card debt, so try to make sure you can pay it in full in your next statement. Typically, you will have more then one investment account. If you are going to need more then $4,000 you can go to your investment accounts to pay for additional expenses. Going into investment accounts is something we always try and avoid, but some emergencies such as job loss may require this to be done.
The other thing to consider is your monthly budget. Now that you are on the path to financial independence, hopefully you are saving money each month. The money you are saving that month the expense occurs can also help fend off part of the expense. In 2-3 months worth of savings, I can fend off a lot of the unexpected material expenses. If one of us loses a job, it is a little more difficult, but we still have enough money in a brokerage account to last us for a year at this point. That does not even include our retirement accounts. Its all about planning.
For every dollar you save, your defense gets stronger. Having a good defense will allow you to be on more aggressive on offense. Offense is saving more and worrying less about the unexpected. The unexpected is now planned for and can be dealt with. Weather you have all your money in savings account or in an investment account, it doesn’t matter as long as you have money to defend against the unpredictability of life. The question of if you need an emergency account or not depends on you. For some people it is more comforting to know they have that money in an account that is easily accessible. For me, I am comfortable with having a smaller amount on hand because I invest so heavily. I know I can get money out of my Vanguard brokerage account if I absolutely need to. I also know I can delay payment with credit cards. Using all of these tools together, makes me not worry about having 6 months of expenses directly on hand. Think of what life could throw at you and figure out what number you are comfortable with. Be smart and plan for the worst. Build a defense and have confidence that you can figure the solution out for anything thrown at you.