Emergency Funds – A CFP (R) Tells You What You Need

by Neal Frankle, CFP ®

When it comes to emergency funds – one size doesn’t fit all. First, remember that emergency funds are for unforeseen expenses. If you are in debt and can’t get out, you don’t have a problem with emergency cash funds; you have a problem with budgeting.

And it’s important to have a good balance and to know how much you should have on hand. If you have too much, you won’t be earning a good return on your money because it will be sitting idle. If you have too little, you take the risk that you’ll need to sell your investments at the wrong time or, worse, take emergency cash loans.

emergency funds

Just because an expense only comes up once in a while doesn’t mean it’s an emergency. You only pay property tax annually, but it’s foreseeable. So are car repairs, home maintenance and most medical expenses. I say this because while you may not be able to predict exactly how much these items will run and when they’ll occur, if you look back to your checkbook over the last several years, you’ll see that every few months something comes up. You must budget for unknown but foreseeable expenses. (Read my review of You Need A Budget for a good budgeting program.)

But there are true emergencies that are not foreseeable. Your house gets flooded. Your car gets stolen. You get fired at work. Your brother-in-law moves in. These calamities are hard to predict, but when they happen you have to be able to weather the storm. (You can buy insurance to cover most of these tragedies, even unemployment mortgage insurance. But you can’t get insurance for everything. Don’t kid yourself.)

Determining how much you need for emergencies is not all that difficult. Just remember that it’s not an exact science, but do your best anyway.

The first approach is to think back over your financial life over the last 10 years. Ask yourself one question.

What was the greatest amount of money you ever had to get your hands on quickly?

If you never encountered a big problem, think about your friends and family. What was the greatest amount they ever had to access immediately? That’s one measure of what kind of emergency funds you need.

Several years ago our drainage decided to launch a stealth attack on our kitchen. Water backed up into our entire first floor, and the battle was over before it began. My wife and I had to spend about $50,000 (after the insurance payments) in order to clean up the mess and replace our kitchen. That tells me I need at least $50,000 as an emergency fund.

Of course, this is one way to gauge your emergency fund needs, but that doesn’t give you the whole picture. Ask yourself one more question.

How stable is your income?

If you’re self-employed, your income might actually be more stable than if you work for someone.

Be reasonable. When is that last time you lost your job? How long were you unemployed? Double that amount and you have your second element of emergency funds requirements.

When you think about your income, anything can happen. You COULD lose your job or your business, but how likely is it? More important, how likely is it to happen immediately? How long would it take you to replace that income?

The third, and most important element of calculating how much you need to sock away for emergency funds is your spending. If you don’t know how much it costs you to live, it will be impossible for you to really know how much you need for emergencies.

Think about the example above. If you think it’s possible that you could be unemployed (in a poor economy like our present situation) for a year, you better know what it costs you to live for a year if you want to know how much you should have stashed away.

Having said all this, you may not need an emergency fund separate from your investments and savings.

If your investments are liquid, you would be able to access those funds if something happened…right? Again…I’m not talking about using your savings to make up for poor budgeting. I’m suggesting that you can rely on your liquid savings for truly unforeseen emergencies.

Some people feel that this approach is imprudent. They argue that if you need the money and it’s in the stock market and the market is down when you need it, it would be a bad time to liquidate.

That’s true. But consider that if the chances of needing to tap into the emergency funds are low (that’s why they call it an emergency) the chances are high that your savings and investments will stay invested. Furthermore, the chances of having an emergency at a time when the market is poor are even lower.

For that reason, you may not need to keep a ton of cash in an emergency fund. Just know how much you need to have and make sure to build up that account.

How do you determine how much you need for emergencies? How do you keep it invested?

photo by Chris.Violette, Flikr

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{ 2 comments… read them below or add one }

retirebyforty December 1, 2010 at 7:34 PM

Oh wow, $50,000 down the drain. That’s terrible, sorry to hear that.
I keep about 4 months of expense in a saving account. If I need more money than that I will liquidate some stock investments.
Over the last few years the biggest amount we needed was $17k to purchase a vehicle. Our saving + a few months of saving was enough for that.

Take a look at my money flowchart and give me some feedback. :)
http://retireby40.org/2010/11/retirebyfortys-money-flowchart/

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Ronald Dodge December 1, 2010 at 10:27 AM

I take a somewhat different approach to emergency funding, but a lot of the points above are still quite valid. For me, a lot of Neal’s story is similar to mine except I didn’t have a large lump sum of money fall onto my lap at a young age. The only thing I did have though, my grandmother did pay for my rent, which included water, but nothing else. Other than that, I had to live on $4,000 annually in the mid 1990’s covering all other expenses while putting myself through college with what sources I could get my hands on. I even lived strictly on Child SSDI until they cut me off from it cause of the money I earned via the College Work Study program as part of my financial aid in college triggered the SGA formula. On the other hand, I also knew I didn’t want to be living like that in my elder years as I did in my college years just getting by literally in survival mode.

While most people look at me like I’m crazy for using depreciation to help determine what I need to do with our emergency fund, I’m like, I use depreciation on long-term assets for 3 reasons:

Determining what is the real cost of such long-term assets when broken down to the day, week, month, year or what ever periodic time period you want to use.

Determine how much money needs to be put off to the side to cover such repair/replacement costs when they do happen (I’m with Neal, these costs are not truly financial emergencies as they are foreseeable, but they still have a significant impact on finances)

Third, but not least, by doing it for the first 2 reasons, it’s also to avoid having to take out a debt on such long-term assets.

The 3 reasons people in general tend to think of when using depreciation are:

Taxation (not a factor for me given it’s personal taxes, not business or charity tax impacts)

Charity (again, dealing with cost basis for such assets)

Business (again, this is for personal finances, not for a business, thus Financial Accounting isn’t needed to send reports to other people).

As such, none of these 3 reasons fits as to why I use depreciation but rather the initial 3 reasons I stated earlier are the reasons why I do it.

Has it help out with our financial picture?

Most definitely as I just had a major repair on my car and I was able to tap into my emergency fund without any issues and get it resolved. Granted, it took about 2 weeks for it to become available to use, but the use of the credit card also covered that time gap.

Speaking of which, credit cards is a great tool for such time gaps as long as you have the available credit for it and you don’t overuse it. The key to using the credit card, you must setup a realistic budget and you can’t exceed that budget (Hence why my Excel financial file serves as my financial advisor, even with me having created the file and there are limitations to it. On the other hand, it has really saved us in many respects as it helped greatly keeping our spending down to a limit).

As far back as February 2001 (when income finally went high enough to cover necessary living expenses), our Long-Term and Short-Term networth value hit a bottom of about ($80,000.00). Yes, you read that right, almost 6 digits into the hole using the accrual basis of Accounting. Now, our Short-Term networth value is about $12,600 and Long-Term networth value is about $66,000. Note, that’s also converting all pre-tax items to after tax basis and as for retirement funds that’s pre-tax based, assuming that tax rate is 43.1%, so the values given above are after tax based numbers, not pre-tax based numbers. The reason why I convert pre-tax to after tax basis, all other numbers are after tax basis, so to be able to compare apples to apples instead of apples to oranges, you must have all numbers to the same basis.

As for windfall, I did get a windfall in July 2009, but of a much smaller amount than Neal. It did help us though significantly as it got us over that one major hump and onto the next major hump. Between that windfall and the over time with the other fact my wife was working in the fall of 2009, we essentially got rid of one debt (though not entirely as otherwise, I would have been hit with the early payoff penalty charge, which that debt will be wiped entirely out in 2011), built up our emergency fund up to 4 months, though it did drop back to 3 months earlier this year, and we also set our focus on the mortgage account to get it down below the amount to get rid of the MIP. Getting the mortgage that far down is the next major hump, which we are not over yet, but this year along, about 18% of gross income has went to that goal and we are about 55% of the way there.

As a result of recent events though, that goal has been temporarily halted and our focus having to shift back to the emergency fund to get it back up to that certain point. This goal though of getting rid of the MIP should be resumed come March of 2011.

Do I consider myself in pretty good financial fitness?

With regards to my approach, yes, very much so. As for are our numbers there yet, far from it. However, as of Fall of last year, the snowball effect of what I been doing all along has started to show itself. Note, I did say start, so it means while the momentum is picking up, we still have plenty of work ahead of us. That work is a matter of sticking to the general plan and making adjustments as needed.

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