Mastering Your Emergency Fund – 101 to genius-level

Emergency funds get you back in control of your money. Having a cash cushion protects you from bad news and surprises.

Here, we will consider what an Emergency Fund is, how to build it, how to protect it and how it interacts with financial independence. This in-depth article will take you through all the key information around emergency funds.

But first, we need to consider why you need an emergency fund.

Why build an Emergency Fund?

An emergency fund’s purpose is to allow you to pay for unplanned expenses.

There are only two certainties in life – death and bills.

One of the things death and bills have in common is that they are, by nature, unpredictable. You can’t always plan them.

That’s one of the reasons budgets and tracking expenses don’t always work. You can have the most detailed plan for life, and then a bolt from the blue occurs and knocks you off-course.

Certain events are so unexpected that you would swear they were impossible.

Some people call these black swan events. Nobody in the northern hemisphere imagined a black-swan event could occur. Until, that is, they travelled south and discovered thousands of them.

Other bills you could predict will happen one day, but you can’t tell when. You know that one day you will need money for a new oven. But that could be in one week or ten years. You can’t predict it.

There are a few different types of event that an emergency fund is there to cover.

Events an Emergency Fund might cover

Loss of Income

You can lose your job in an instant. Companies go bankrupt. Scandals erupt. Pandemics reign. Plagues of frogs fall from the sky. It happens.

An emergency fund is there to cover necessary expenses until you can replace your income.

Predictable bill, unexpected timing

Some expenses are regular. They come along every day, or week or month. I’m thinking things like food, electricity, water and so on. Other bills you can plan for and save for.

If you need a new oven, you can plan that years in advance and have money saved ready to buy it. Unless, the oven breaks before you are ready.

An oven breaking, the car engine grinding to a halt, the cat knocking the new flat screen TV. The costs to repair or replace these items might have been predictable, but the timing is anything but.

An emergency fund is there to pay for predictable bills with unexpected timing.

Unexpected emergency situation

These are the unknown unkowns. Something completely out of the blue. You get sued. Your accused of a crime. You lock yourself out of the house. Use your imagination. You need to be ready.

An emergency fund is there to pay for unexpected emergencies.

Example of money emergencies

• Medical bills
• Vet or pet bills
• Dental bills
• Repairs of boiler, air conditioning, oven, television, laptop, refrigerator
• Car repairs
• Electrical, water, sewage or gas faults.
• Legal issues – prosecution, being sued, needing to sue
• Victim of crime: burglary, mugging, fraud
• Unexpected tax bills
• Excess on insurance
• Damaged or lost property – lost wallet, glasses, phone.
• Unplanned travel – sick relatives, surprise parties, wedding invitations
• Gifts for surprise events like engagements, weddings, surprise parties and funerals

Really, the list of unplanned expenses is endless. If it’s not spend you can predict or reasonably avoid, it’s an emergency.

Other reasons to have an emergency fund

Beyond self-insurance, there’s a few other reasons to carry an emergency fund.

Peace of mind

Don’t underestimate the mental wellbeing boost you can get from knowing you are prepared for unexpected financial risks. It can help you to sleep soundly at night

Learning financial discipline

An emergency fund may be the first time you have saved with a purpose. That’s a great thing. Saving is the cornerstone of all money mastery. Sometimes it can feel at little aimless. Now, you have a purpose. Save so you have a good pot of money for an unexpected event.

Avoiding paying interest

Paying interest is how bankers make their money. If you want to make yourself rich rather than bankers, building an emergency fund reduces the risk of you lining the bankers pockets.

What is an Emergency Fund?

An emergency fund is money you can access fast if you need it for an unplanned event.

Emergencies normally have the following characteristics:

• An unexpected or unplanned event occurs – creating a problem.
• Money is required urgently to fix the problem.

The emergency fund is your money that you can access to fix the problem. It’s as simple as that.

By now you may have realised, another word for emergency fund is savings!

What is the difference between an Emergency Fund and Insurance?

An Emergency Fund is personal insurance. It is your own back-up plan.

A good question you may be asking is, why not just rely on insurance from third parties? Isn’t that what insurance is for afterall?

Why you can’t just rely on third party insurance

Third party insurance has deductibles / excesses

Most insurance requires you to pay a share towards the insurance. This is generally a good thing. It makes you more cautious and careful in your activities if you know you might have to pay. It keeps your “skin-in-the-game” and actually keeps the cost of insurance premiums down.

But, it means that in an emergency you will need to find some money. Paying excess insurance is a perfect example of why you need an emergency fund. This is how you will pay it.

Third party insurance doesn’t cover all emergencies

Insurance can be great for specific emergencies. If somebody drives into you car, that is normally covered.

But even if you buy all the insurance add-ons there may be costs the insurer doesn’t cover.

A perfect example of this are smallish amounts, below the amount of your deductible / excess. By definition, there’s no point claiming on your insurance because you aren’t covered. That’s where an emergency fund comes in!

Third party insurers are out to make a profit

Insurers are profit maximising businesses. They take on the risks from many people, and runs some complex maths to decide how much to charge those people. That maths always includes a profit margin.

That means when you buy insurance you are paying more than your share of risk.

Let’s say the chance of a boiler breaking down is 10% each year, and costs $500 to fix. That means the expected cost is $50 – that’s 10% of $500. An insurer will not charge you $50 to protect you. They will always charge you more. This protects their downside risk, plus all the overheads and marketing of running the business, and also gives them an expected profit. So, say they charge you $80. That means they are expecting a $10 profit from your contract.

There’s nothing wrong with insurers making a profit. It’s a reward for running their business.

For you, paying $80 every year may be much better than having a one-off $500. You need a boiler after all, and if you couldn’t afford one you would be in big trouble.

That is, unless you have $500 available in your emergency fund. Rather than spend $80 each year, which is $800 over ten years, you have $500 in your emergency fund and save $300 over 10 years!

Third party insurers don’t alway pay out

A sad truth is that some honest insurance claims aren’t paid out. Insurers are experts at finding ways to not pay out on a claim. Either you filled in your details inaccurately, or the small print meaning is different to what you understood. You cannot rely on insurers to cover everything.

So we’ve seen the downsides of third party insurers, but please don’t think this means you shouldn’t also have third party insurance. Emergency funds work together with insurance to ensure you are always covered in the event of an unplanned expense.

Where Should I Keep My Emergency Fund?

In order fix unexpected money emergencies, you want to have an emergency fund that is highly liquid, secure and not volatile:

• Highly liquid
  • You need to be able to have instant access to the cash.
• Secure
  • You need confidence that the money can’t be stolen or lost.
• Stable – Non-volatile
  • You need confidence that the money will be worth what you need it to be worth.

Let’s break down each of these qualities in a little more detail.

Highly liquid

You must be able to access the money you have saved in an emergency fund. If you can’t access the money quickly, that may be a real problem depending on the emergency.

If you need to give days or weeks of notice to get hold of the money, it does not work as a true emergency fund. When someone is brought into the emergency room on a TV show, you don’t see the medics saying they will get to work in a few days after the funds have cleared.

Emergency funds should be highly liquid.

Secure

Once you have built up your emergency fund, you need to be sure it stays secure. That is, it can’t be accidentally spent, or deliberately lost or stolen.

For example, keeping your emergency fund as cash in your purse or wallet might seem like a great idea. Until you are mugged.

Similarly, relying on credit cards might seem like a clever shortcut to building an emergency fund, until the bank cuts your line of credit.

Emergency funds should be kept secure.

Stable / Non-volatile

Volatility means something changes unexpectedly. In money terms, your investment is volatile if it frequently changes in value.

For example, if you owned shares in a company, the market value is liable to change minute-by-minute. Shares are volatile.

Similarly, if you hold a money in a foreign currency, the exchange rate between the currencies will change day-to-do. Foreign currencies are volatile.

Emergency funds should be kept as stable, non-volatile assets

Comparing different places to keep your emergency fund

For most people, a separate current account or instant access savings account will be the best place to keep their emergency fund. These accounts meets the three tests of high liquidity, security and stability.

Should I care about earning interest on my emergency fund money?

You may have noticed a significant omission from the test of place to put the Emergency Fund. There is no test here about what yield or return might be expected to be from interest, dividends, or capital gains.

This is because your emergency fund is not an investment. The purpose is not to make money from an emergency fund. The purpose is to prevent you losing money. It’s a form of insurance.

If you can find a highly liquid, secure, non-volatile place to hold your emergency fund that ALSO pays you interest. Great. Go for it. But don’t decide only because of this. Don’t let the tail wag the dog.

But what about inflation?

The “cost” of holding your emergency fund in cash is that it will be eroded by inflation. This is the cost you pay for high-liquidity, security and stability. Again, earning interest to offset this would be an excellent idea.

How much money should I keep in my Emergency Fund?

By definition, you don’t know exactly what the emergency will be. All you know is that something will happen. So how do you decide how much to hold as an emergency fund?

But we can do a little thinking on the subject by looking at the choice through a few different angles.

First, if you needed the fund because you lost your job. In this scenario, the emergency fund would need to cover your necessary expenses until you have an income again.

So here, the real question is how long it would take you to have an income again. Assuming you lost your income unexpectedly, it may be months before you can find a new job. If it’s the result of a wider recession or something like the Covid-19 pandemic, that time could stretch even further.

You should look at your own industry and level to help understand how difficult finding a new job will be. Assume you are not the only one out of work.

As a rule-of-thumb, I would suggest planning at least three months expenses. A more secure income protection would be twelve months.

Note: You could also look for ways to spend less money to help with only necessary expenses.

Second, if you have a planned expense but unexpected timing. Things like the oven breaking. Assuming you have no insurance, you should think of a bad-case scenario. How many unexpected spend could you handle at once. Could you handle the oven. Ok. And the dishwasher? Great. And a car repair. Getting tougher? And a broken window.

Make the scenario gloomy but possible. How much would it cost if you added these all together. That’s your rainy day need.

The standard recommendation is three to six months necessary expenses. A more prudent position would be twelve months.

It’s worth noting that the longer your fund, the more time you will have to come up with alternatives. It gives you time to access locked up funds. It gives you time to access loan financing, or to retrain for a new job.

How do I build up my Emergency Fund?

If you have no savings at all, your emergency fund represents your first savings.

You will need to save money or increase your income to build an emergency fund. This is not something you can borrow money to achieve.

This post won’t go into detail on saving money or increasing your income. But here is the rule:

Spend less than you earn.

The following table illustrates how quickly you can build up a three month emergency fund for different levels of savings.

As you can see from the table, the more you are able to save from your gross income each month, the faster you will build up your emergency fund. Your gross income is your total income before taxes are deducted. Note: this table assumes no interest accumulated on the savings because we want this money highly liquid, secure and stable.

For example, if you were able to save 30% of your total income, it would take 0.6 years or 7 months to have a three-month emergency fund in place. Any savings of 20% or more of gross income and you will have your emergency fund in place within a year.

Understanding your savings rate is a wonderful thing for your money.

Importantly, if you have to use your savings fund for an emergency, do it. Then continue to work to build up your fund. If you find yourself spending the emergency fund, but not on emergencies, then you aren’t really saving the money. You need to find a more effective way to save.

Downsides of an Emergency Funds

So far, I hope I’ve done a good job of convincing you that need a fund. You might be beginning to think you should keep all of your assets as an emergency fund.

There are a couple downside to emergency funds which we should cover here.

Your fund is not invested

Your fund is not there to generate returns. It won’t make you rich. It’s protecting you from being poor. But this means, if you want to be rich, you don’t need an enormous emergency fund. Just enough to buy you time if things go wrong.

Your fund is not paying off debt

Your fund isn’t paying off any debts you have. That’s ok. In an emergency, you are liable to generate more debts, until the point where the banks won’t loan to you anymore. Or only at extortionate interest rates. But don’t have an enormous emergency fund at the expense of paying off high-interest debts.

Emergency Fund as part of Financial Independence

If you are on the journey towards financial independence there are some specific questions to consider around Emergency Funds.

Should you include your Emergency Fund in your Financial Independence assets?

I recommend you do not include your emergency fund in the calculation of your Financial Independence number.

To recap, your FI number is the amount of investments you need to be able to live on them for the rest of your life. The classical calculation is your annual expense multiplied by 1/your safe withdrawal rate.

Because your emergency fund either makes no return or a very low return, it will dilute your safe withdrawal rate.

Advanced Emergency Funds

As a beginner in finance, you just need to focus on building up an emergency fund and keeping it replenished.

But as you build up other assets, you may choose to adjust your approach to your emergency fund.

The fund assumes you have no other assets to draw upon. And ideally, you never have to draw on your emergency fund. Combined this implies that you may be better to invest more of your money in better returning assets like global, low-cost, index fund trackers. These are not quite as liquid and far more volatile than holding cash. But in return for these risks, the expected returns are far better.

You may choose to have some of your investments as part of your “insurance policy” in the event of an emergency. This would mean potentially selling your investments at a loss. If you are prepared to trade this risk for the potential rewards, this is an option to consider.

Alternatively, you may consider one of the “emergencies” your fund can cover is buying dips in the market. In other words, your emergency fund morphs into your cash pile awaiting good investment opportunities. It is a good idea to always have cash available to leap on opportunities. Here, you are trading current low returns on your cash for anticipated better returns for investing when others are selling.

Short term liquidity can also be found in credit cards, lines of credit/HELOCs etc. This should be done with extreme caution. It is very easy to accidentally fall into debt and start paying interest if you use credit to fund emergencies.

As I say, these are more advanced emergency fund strategies. Be sure to have a strong asset base before considering any of them. I’m always surprised that the more money someone has, the higher their unexpected emergency costs seem to be.

Other resources to help you build up your emergency fund

Here, I’ve gathered some key references to building your emergency fund from great thinkers around the web.

Major unexpected expenses from MoneyCrashers.com

TL;DR

In summary, if you found this too long and didn’t read:

• Build up an emergency fund of 3 to 12 months of necessary expenses.
• Keep the emergency fund somewhere highly-liquid, secure, and stable – for example, a local currency instant access savings account.
• If you save 20% of your income, it will take one year to have a three-month expenses emergency fund.
• Replenish your emergency fund if it gets uses up.
• Use third-party insurance to cover for major emergencies.

What’s next?

Once you have built up a secure emergency fund, you have a strong foundation to continue your journey towards mastering your money.

You have proven you can save money and keep it saved.

Now, don’t start spending more. Why not consider the ten building blocks of financial independence.