The Emergency Fund: The Account You Need That Won’t Make You Money

According to the ancient Greek philosopher, Heraclitus:

“The only constant in life is change.”

This has been true for literally all of human history.  You can be absolutely certain that everything that is true about you now, including your family, your career, and your income, is subject to change in the future.  

Unexpected things come up, and big expenses have a way of coming up at the worst possible time.  You need a financial cushion to catch these expenses and prevent yourself from having to dip into your savings to make ends meet.  

It doesn’t matter what your level of income is, your level of debt, or the size of your nest egg.  All it takes is one giant medical expense, a natural disaster, a malpractice suit, a layoff, or a messy divorce to completely destroy all the wealth building progress you’ve been making.   

I’ve read a lot of financial blogs, including a lot of blogs directed at high-income earners.  I’ve observed a disturbing trend in which some of these financial thought leaders are advising against maintaining a healthy emergency fund.  

This is an extremely hazardous approach to your finances.  Wise investors learn how to play good offense by investing well and avoiding taxes, but they also play good defense by spending less than they make and having safeguards in place to prevent catastrophic loss of the money they have invested.  

The emergency fund needs to be part of your wealth building strategy.  

Common arguments against an emergency fund

1. You won’t make much money because it’s in a simple savings account. 

This is absolutely true! 

But making a big return on the investment isn’t the point of the emergency fund.  The point is to have money available to use in the event of an unexpected major expense.  

The emergency fund isn’t an investment, it’s insurance!  Insurance costs you money, it doesn’t make you money.  

In this case, the money you’re missing out on is the higher rate of return you could get with other investments.  That’s ok, though, because the money will be totally safe in the savings account, not at risk for loss like in the stock market.  

You want this money to be available anytime you have an emergency, so you can’t afford to put it at risk.  The higher security means lower returns, but it’s worth it to have this available when (not if) an emergency arises.

2. You can use a credit card or HELOC for emergencies.

Yes, and you can drive a car with your feet, but neither of those is a good idea.  

A financial emergency is the WORST time to take on new debt.  

If you think you’ll be able to replenish the emergency fund and pay off the debt really quickly, could that work out for you?  Sure, but it only works if it works out perfectly, and you can’t guarantee that.  

Don’t let yourself fall into the trap of using debt as the crutch to save you every time you want or need to buy something.  You’ll end up losing money on interest payments your whole life, instead of earning interest with that money sitting in the bank.  It doesn’t matter if you can get a low-interest loan on a HELOC or a credit card.  Don’t use debt for short-term emergencies.  Plan ahead and pay for them.  

3. If you have the right kind of insurance, an emergency fund is superfluous.

While you do need to have the right kinds of insurance, not all financial emergencies are covered by insurance plans.  If a family member dies across the country and you need to fly your family out on short notice, that won’t be covered by insurance.  Many medical expenses won’t be covered or will only be partially covered by insurance.  Big car repairs like a broken transmission won’t be covered by insurance.  

You should have an emergency fund to complement your insurance coverage, not to replace it.  

How much should I have in an emergency fund?

This is a challenging question, and the answer depends on your current level of income, household expenses, and level of debt.  

My general recommendation is that a fully funded emergency fund should be sufficient to cover three to six months of essential household expenses (utilities, rent/mortgage, food, insurance, transportation), not counting entertainment, gifts, or “extras.”  Depending on your level of income and expenses, that could range from $10,000 to $50,000.  

If you have a really steady job, say as a military physician, you could probably get away with three months of expenses because you have less of a chance that a layoff or malpractice suit will happen.  If you have a job purely based on commission or if you have other instabilities in your income, you might want to aim closer to six months of expenses.  

Basically, you want enough in the fund that if you lost all of your income today, you could live on the money in the emergency fund long enough to establish a new source of income for your family.  

Note that we’re talking about a fully funded emergency fund here.  I feel strongly that you should take an aggressive approach to paying off debt, especially early in your career, and saving up money in the emergency fund does detract from that goal.  

If you’ve ever listened to Dave Ramsey, you’ll know that he talks about first getting a $1,000 emergency fund, then paying off all debt very aggressively, then increasing the emergency fund to three to six months of expenses.  I think that’s a really good approach for the majority of people, and I’ve coached many people using that method, with great results.  

However, Dave and I make exceptions for folks with extremely high levels of debt, such as newly graduated physicians, dentists, nurse practitioners, and physician’s assistants.  It takes so long to pay off that debt that you can’t really afford the risk of having only $1,000 in your emergency fund for that many years.  This is what I propose as a starter emergency fund for people that are aggressively paying down debt.  

          Debt level             Time to pay off debt           Emergency fund  

< $100,000                                 <1 year                                $1,000-$2,000

 $100,000-$250,000                1-2 years                              $2,000-$5,000

 $250,000-$500,000                3-4 years                             $5,000-$10,000

> $500,000                                >4 years                               $10,000-$20,000

This starter emergency fund concept only applies to you if you’re going to get serious about paying off debt.  If you’re planning to keep your debt payments around for a decade or two, you should probably just go ahead with building the fully funded emergency fund now.  

If you’re going to get really serious and pay off all your debt in 2-4 years, then the starter emergency fund is a good place to start.  

You’re thinking, “That’s not enough for a huge emergency.”  You’re right, it’s not.  This only works in the context of you getting fired up about getting the debt yolk off of your neck quickly.  You need a plan to get that debt crushed in a few years, after which you’ll be able to build the full emergency fund very quickly. 

What investment vehicle should I use for my emergency fund?

I recommend keeping your emergency fund in a simple savings account or a money market account.  There are three factors that should influence your choice: safety, returns, and accessibility.  

Safety: You want the money to not be at risk for loss.  This guaranteed security of the principle will ensure lower returns, but that’s ok.  Remember, this is insurance, not an investment.  

Returns: You want a very low or no risk investment like a savings account.  You probably won’t get more than about 2-3% return on your money, but it’s better than you paying a credit card company 18% to fund your emergency.  

Accessibility: You also want the money accessible enough to pull out in an emergency, but you need to put some safeguards up for yourself so you don’t use it to buy a Jet-ski or some other impulse purchase.  When you’re first starting out, consider having this money in a separate account or even a separate bank from the one that you usually transact with.  You do want the money accessible, but don’t tempt yourself to blow it all on a non-emergency.

An essential part of your plan

This is the part of investing that is boring.  It’s easy to get excited about buying a house or picking a new stock to buy, but an emergency fund feels kind of like getting the oil changed in your car.  

It’s necessary, but it’s not something you really look forward to.  Trust me, if you ever experience a true financial emergency, you’ll be so relieved that you have this money set aside for yourself.  Use the emergency fund to protect your investments from what life throws at you.  Be intentional, and make this an integral part of your plan. 

Leave a comment below and tell us about a time when you experienced an event that made you really glad you had an emergency fund, or that made you wish you’d had an emergency fund.  

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