Rainy Day, Rainy Month or Rainy Year
Hi folks! Welcome to The Green Swan. Today we are going to chat a bit about emergency funds and, specifically, one of the major points of contention I have with them. I would even go so far as to call it an Emergency Fund Myth! What is it, you ask? The myth is the common guidance to set aside three to six months of living expenses (yes, I’m looking at you Dave Ramsey…). When establishing an emergency fund, what it comes down to is determining what exactly you are insuring for and if there are better alternatives.
Why Dave Ramsey is Wrong
Let me start by saying that Dave Ramsey isn’t entirely wrong on this topic. He makes a good point that the amount depends on your individual circumstances. For example, if you are in a two-income household then the lower end of the range may be appropriate. But if you are a single-income household or don’t have predictable income (e.g. paid on commission) then the higher end of the range may be advisable. That is what Dave Ramsey suggests and I think the consideration of the stability of your income is important to factor into your comfort level of how much liquidity to maintain in your emergency fund.
However, the premise that three months should be set aside for a two-income household still seems extreme. For a typical middle-class household, monthly expenses may amount to $4k-$5k (this is a bit of a SWAG, but it gets us in the right ballpark). I can say that my household is a bit north of this when including the mortgage, a kid in daycare, our car payment, and other normal living expenses. But based on the SWAG, Dave Ramsey would be suggesting an account set aside with $12k-$15k! Hold on…my jaw just hit the ground…yes $12k-$15k!
No way, Dave! What’s next, stock away canned vegetables and wait for the apocalypse?
My Emergency Fund
Right now you may be wondering how much money I keep liquid (i.e. checking or savings account). Well, it fluctuates weekly based primarily on the timing of paychecks and my monthly credit card payment and mortgage, but my target is approximately $3k. This amounts to just over about 50%-60% of an average month-worth of expenses, or about two to three weeks.
No, I’m not joking, and no, I’m not crazy (well, not clinically diagnosed anyway…).
Why 3+ Months!
Here are some of the common reasons an emergency fund is suggested:
- Job loss
- Medical Expenses
- Home Repair
- Car Repair
Let’s tackle these one by one.
Yes, job loss is the most common and, to me, important reason to maintaining an emergency fund. But I still think three months is overkill. Why? First off, if you are laid off from your job, you will be able to claim unemployment benefits. Depending on your employer and job function, you may also be given a severance package. While unemployment benefits vary state by state, it typically offers 40%-50% income replacement for a standard of six months. That is pretty good if you ask me, especially since your expenses presumably do not amount to 100% of your previous income and you can presumably temporarily rely more on your spouses’ income.
If you are laid off, go out and get another job as soon as possible. Even if that means you are “underemployed” for a period of time, you would at least be bringing in some money once again. According to survey by Money, the average length of time to find a new job is just over 6 weeks (or 43 days). Even if in a so-called “worst case” where it took 6 months, rather than 6 weeks, to find a new job, and you were collecting about 50% of your previous income from unemployment benefits, you will still have excess cash in your three month emergency fund. This begs the question if in a “worst case” scenario you wouldn’t utilize your entire emergency fund, why retain such a huge amount in cash?
Medical expenses can very easily pop up out of nowhere and put a dent into a budget. But does that mean you need to set aside $12k-$15k? NO! Assuming you have health insurance that is. Yes, you will have some out of pocket costs, but it likely will be more manageable. Most folks these days have high deductible health plans, meaning the first dollar of medical expense comes from your wallet/purse. But according to the annual Kaiser Family Foundation Survey of Health Benefits, the average deductible for an individual in 2015 was just over $1.3K. Yes, that would be a hard pill to swallow (sorry for the pun), but not something that would call for a massive emergency fund.
Plus, let’s keep in mind that if you did incur a large medical expense, you don’t have to pay for it immediately. Typically the bill will come a month later, and the bill may not actually be due for another month, and if you pay with a credit card, you won’t have to pay that off in full for maybe another month. That gives you plenty of time to save some more money before you actually pay the bill with cash from your emergency fund.
An alternative to using your emergency fund for medical expenses would be a Health Savings Account (H.S.A.) which are commonly paired with high deductible health plans. Pre-tax dollars can often be set aside in an H.S.A., with investment options available including stock and bond mutual funds, and easily available to pay for medical claims.
What if you have an illness that keeps you from going back to work? Many employers over short term disability insurance, but even if your employer doesn’t this can be purchased (have you ever seen the Aflac commercials with the duck…?).
As with everything in life, it is important to review your options and not just default to conventional wisdom. If you are adequately insured, or at least understand the risks of being under-insured or “self-insured”, then a large emergency fund may not be completely necessary.
If you are a homeowner, then you know the “joys” of being a homeowner. That means random projects and repairs…constantly. But does that mean you need a massive emergency fund? NO! One alternative to an emergency fund is a home warranty insurance plan which helps with surprise expenses. This may cost a $100-$200 per year which isn’t too bad.
I’m not a big fan of insurance generally, and definitely not a proponent of home warranty insurance as it seems like more often than not there is a hole in the policy and the insurance company finds an “out” to avoid paying the claim. That has been my personal experience anyway.
But putting that aside, some of the big home repair expenses you may incur could be replacing the roof, water heater, furnace, or A/C unit. And I think the only reason you would need a $12k-$15k emergency fund would be if all four went out at the same time! A roof costs about $5-6k, water heater may cost $1k, furnace around $3k, and an A/C unit may be $4k. While I note these are approximate costs which vary by geography, size of home, and other considerations, but also serve as a good SWAG.
Plus, again, repairing/replacing big items like these for your house doesn’t mean you have to pay cash from your emergency fund on day one. Many times you could cheaply finance these purchases, or the bill may not come due for a month or so. All of which could give you time to build more cash to pay in full.
Again, it is important to review options and opportunity costs. Defaulting to the conventional wisdom of retaining a large cash emergency fund may not be necessary for everyone.
Another major cost that can jump out of nowhere is a surprise car repair. Now granted, if you have an aging car, you can expect more frequent repairs and maintain more cushion in your emergency fund. For the sake of sounding like a broken record, does that mean you need a massive emergency fund? NO! According to AAA, the 2015 average maintenance cost per year for an average sedan is 5.11 cents per mile, or $766.50 per year assuming 15,000 miles driven.
This would be a big expense when sprung on you all of a sudden, but not something that needs to break the bank. And don’t forget, this can be put on the credit card and paid off in full a month later, delaying the time when cash is paid from the emergency fund.
If the unfortunate situation arises where you have an at-fault car accident, which can potentially result in significant and numerous financial considerations, this may not materially necessarily be a job for the emergency fund. This ideally would be a job for your insurance company with the deductible being the primary out of pocket cost.
Detailed below are my considerations:
- Job loss is number one for us. Although we both have stable incomes, we both receive bonuses as a material part of our overall compensation. We don’t rely on this income though and know that it is at our employers’ discretion. Also, we both feel very secure in our jobs for various reasons, and are comfortable knowing we won’t be laid off in the foreseeable future.
- Medical expenses can surprise anyone, even if they are generally healthy individuals. We have an H.S.A. account that would help us in case of a medical emergency as well as good health insurance coverage. Additionally, we both have short term disability provided by our employers. Our H.S.A. isn’t just sitting idle though, we have it entirely invested in the stock market.
- Home repair is not a big consideration for us necessarily. We just replaced our roof last year (before installing solar panels) and our A/C units are new. We may need to replace the water heater and furnace in the near term.
- Car repair isn’t a major concern either. Our one car is new, and the other, although about 10 years old, has only 80,000 miles on it and runs well.
Rainy Day, Rainy Month or Rainy Year Fund?
With all that said, do you need a rainy day, rainy month, or rainy year fund? Everyone’s approach here will depend on individual circumstances and comfort level. And it depends on how big of a fortress you want and the opportunity cost associated with maintaining extra liquidity (rather than investing in the stock market, etc).
That is right, there are alternatives to Dave Ramsey’s recommendation to retain your emergency fund in a separate cash account. That means factoring in opportunity costs is a major consideration. I plan on delving into this in further detail in a follow-up post next week so stay tuned.
Finally, I would suggest not thinking of it as a time period of expenses you need to cover (e.g. 3 months’ worth) and instead a flat dollar amount of cushion you want to maintain. For me, maintaining no less than $3k suffices based on my main considerations above, our insurance deductibles, etc. My wife and I have run our lives with this much cushion for ten years now and it has never failed us.
There is definitely more to discuss when it comes to emergency funds, but this is getting long so let’s put a pin in it there. For more, check out my emergency fund alternatives.
Tell me about your emergency fund. Do you have a target amount of liquidity you maintain? Is it based on months of expenses or potential major cost factors? Has your emergency fund ever fallen short and if so, how did you handle it?
Thanks for taking a look!
The Green Swan
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