Emergency Fund, Why and How
By Xiaomin Guo, Ph.D., CFP®
TAMPA (December 4, 2020) -- Life is full of surprises, from a lottery award to a promotion, from a broken arm to a car accident. Sometimes we may not have a strong feeling that we are better off with the positive change in life. However, we do feel significantly worse off with the unexpected expenditures or the sudden negative financial disruption of income. To provide ourselves a safety net, the golden rule of budgeting is that we keep an emergency fund covering three to six months of monthly non-discretionary expenses that maintain our basic living demand such as food, utility bills, rents, mortgage payments, insurance payments, etc.
As the emergency fund needs to be kept in a very liquid way (cash or cash equivalent, and short-term securities) so that it can really solve the emergency as soon as it happens, the potential return has to be sacrificed as the current average savings interest rate is still lower than 1%, even for short-term CDs. Besides, you may over contribute to the emergency fund and miss the potential tax benefit which you could obtain if investing the money elsewhere such as 401(k) or IRA. Gains from the capital market investments may result in higher tax payments, especially if the securities are not held for long or traded too frequently.
So it is essential to conduct a careful evaluation of your personal situation. For monthly expenses, whether church donation or Cable TV is discretionary or a must, totally depends on personal preference. Regarding how long the emergency fund should cover the monthly expenses, three months, six months, or even nine months, it depends on the nature of your income – is it tied to the economy, diversified, or easy to recover once lost. For those who have not ever started an emergency fund, it may be hard but still doable. Cut unnecessary spending now and set aside money little by little to a separate savings account that is out of your immediate reach, ideally. Never rely on credit cards as a better way to fund an emergency, as the aggressive fees and interest rate would only generate a vicious circle, which makes saving for emergency impossible.