An emergency fund can be a vital part of your overall economic and personal finance plan. While I don't believe in having a large part of your net worth in cash that sits in a bank account, an unforeseen accident or emergency can produce an immediate need for instantaneous cash. During times of distress cash is King. An emergency fund is basically cash set aside to pay for emergency expenses.
I'm currently in "accumulation mode". What I mean by that is that I'm currently accumulating assets that will pay me to own them. These assets will fund my early retirement. Because of that, cash really does me little good. Cash in large amounts while I'm trying to accumulate equities provides an opportunity more than anything else. At this current time I think of having large amounts of cash as an opportunity to pounce on stocks when the market prices them at discounts to their intrinsic value. During these times of extremely low interest rates, having lots of money in the bank is counterproductive, as inflation will erode your purchasing power over time. Cash is historically a horrible investment vehicle.
At this time, because I am in accumulation mode, I like to keep 3-4 months worth of expenses in cash. It does fluctuate a bit, as I will drain the emergency fund a bit when the market is down and hold on to slightly larger amounts of cash when the market is up. I like to think of emergency funds in terms of percentages of your expenses, instead of absolute dollar amounts. Because my expenses are fairly low, having $4,000 or so in cash readily available usually suffices for me. Cash is just one part of my emergency fund, however. I also currently have $5,000 in a revolving credit line available to me should a large emergency ever present itself. There are few things these days you can't purchase with a credit card, so this is my ultimate backstop. Of course, I could also sell equities if something truly catastrophic were to happen to me.
An Emergency Fund Should Be Tailored
While I feel the numbers I'm presenting to you today work for me, I think an emergency fund is something that should be uniquely tailored to one's own situation. Some questions that are pertinent include:
* Do you have children?
* Do you own your own home?
* What kind of insurances do you have?
* Do you have elderly family members that you may be responsible for?
* What are your monthly expenses?
* What kind of cash flow do you have?
* Do you have a large number of liabilities? Are you drowning in debt?
* How secure is your employment?
Be Honest With Yourself
These kinds of questions will give you a strong idea as to what kind of emergency fund is appropriate for you. I don't have any children, my family is young, I have fairly low monthly expenses and I rent. I think if you own your own home you should definitely have extra money set aside for household repairs and improvements. I rent, so anything that breaks is the responsibility of my landlord to fix. I have pretty strong cash flow as I currently save well over 50% of my net income. A small emergency could be taken care of by the large buffer I have between income and expenses.
One of the questions I posed deals with debt. If you have large amounts of personal debt like credit cards and car payments (and even a mortgage), your first priority should be reducing and ultimately eliminating that debt. If you have a large amount of money in the bank earning .024% while you're paying 15% on your credit card balance you're doing yourself a disservice. I don't believe in having $0 in the bank, but you should minimize debt at all costs. I currently only have student loan debt. The interest rate is below 3% and it's tax deductible. I'm in no hurry to pay this off at this time.
My personal risks involve insurance. I currently don't own a car or a home, so I carry no insurance for those types of items. However, I currently carry no health insurance. I've been extremely lucky as I've had no major medical issues since hitting adulthood. I'll likely be changing this soon as I approach 30 years old.
Once You Retire
Once I hit my ultimate goal of personal financial freedom by 40 years old, I'll be saying goodbye to the 9-5 (7:30-6 in my case) and saying hello to sleeping in, traveling and spending more time with loved ones. Once I become financially independent and decide to part ways with full-time employment, my buffer between income and expenses will likely be gone. While I still plan on my passive income to exceed my expenses, the buffer of ~70% I currently enjoy will be largely lessened. Because of this, I believe that having at least six months of expenses in cash is crucial. This amount will likely change as I get older. I believe in increasing a cash buffer as you get older due to any medical issues that may arise.
It would also be nice, in my opinion, to have some money in the bank to fund things like a vacation or an outing that you don't usually plan on. Once you're no longer working it may be easier to find things that seem exciting that fall outside the usual budget. These things should be limited, however.
What's your opinion on an emergency fund? Do you have one? Do you think it should be larger than what I listed above? Share your thoughts.
Thanks for reading.