Is 5000 Enough For an Emergency Fund?
Introduction
When I was first starting out on my own, this is a question that I thought a lot about and tried to understand by doing lots of Googling on the topic. For those that search for the answer to this question, the answers are all over the place: some say 3 months, others say 6 months, others yet say a year or more. But what is the right answer?
I would like to give you the answer as quickly as possible on what I do. I currently spend approximately $17,000 year on living expenses and I keep approximately $5,000 in savings; doing the math, that’s approximately 3.5 months of living expenses permanently tied up in savings. The rest I invest.
This is an interesting topic that I have thought a lot about, and correspondingly I have an opinion about. Since I am involved in the manufacturing industry, I have learned the leaner you can make everything better the better off a company will be. Applying this to finances it means the less money you put into savings the better.
Classical advice to the emergency fund:
Traditional advice for the emergency fund varies a lot, but commonly the advice is to have approximately 3-6 months of living expenses saved in a bank account. It is sound advice in my opinion for certain groups of people. If you are just starting out in your career from nothing it can be scary financially and the first priority should be to have peace of mind that you are going to be ok for a few months if something happens.
However, by the time the 6-12 month emergency fund is built up, the focus should start to transition away from simply saving money to how to invest it. I subscribe to the belief that investing in the total stock market is one of the best options, it is safer and offers more returns on average than picking individual stocks. JL Collins has an excellent book explaining why this is the case: The Simple Path to Wealth: Your road map to financial independence and a rich, free life
Every dollar that is saved is not invested
What does this even mean? It means that every year that goes by, the money is being eroded by inflation, losing more and more purchasing power as the years go by. More importantly it is lost potential, because this money could be making you money. Money in a savings account is essentially a deadweight that is pulling your finances down. To put this into perspective, I have approximately $5,000 in savings, this money could be earning 10% interest in a good year, which means that to have $5,000 in emergency savings I am literally losing $5,000 x 0.1 = $500 of potential earnings each year. I am essentially paying a $500 tax just to have emergency savings. However, an emergency fund is a necessary evil you can’t live without. Without it we would not be able to pay the bills or buy the goods we need to live.
Before I continue further I’m going to give a shout out to Mr. Money Mustache, his views on the topic have helped me arrive at a solution that works for me. Here is a link to one of his videos discussing the same topic in great detail: MMM vs. The Emergency Fund – MMM Show Episode 9 I will summarize a part of it below.
Essentially, in a nutshell, the idea is to have a minimal amount of money in savings. If an emergency happens that is greater than what you have in savings all you need to do is sell off some of your other assets, like stocks, to cover this expense.
Potential Risks
No strategy is without risks. The downside to selling stocks is that it usually takes a few days to finally end up in your checking account. For me it usually takes about 5 business days or about 1 week counting the weekends. During this time the money in your checking account needs to be sufficient for an emergency. You might ask, what if it isn’t enough? What if the amount I owe for the emergency exceeds this amount? Well that is where credit cards come into play. With a credit card you can spend money that you don’t have to cover the expense. You have a month to pay off the credit card, and the money from the stock sale easily arrives in that timeframe. The money from the sale of the stocks then is used to pay off the credit card.
A downside that I can see with this strategy is if the emergency can only be paid with a check or cash payment and this amount is greater than what you have in the checking account. Three things have to happen simultaneously for you to get to this point.
- The emergency has to first exceed the amount you have in savings.
- The emergency cannot be covered with a credit card.
- The emergency must be paid in under a week.
I have about $5,000 in savings and I can’t think of many emergencies that would exceed this amount. I also cannot think of many emergencies that require a payment in under a week or accept cash or checks as the only means of payment.
But let’s give this idea even less oxygen. Let’s assume the absolute worst case scenario, let’s say you need to pay a large lump of money in cash right now and it needs to be in cash. This is where the last resort of asking friends and family comes in. If this is not an option you have very few options. I am not a statistician but I would say the probability of this happening is extremely low. A perfect storm of events would need to happen for you to end up in this scenario given the assumption that the amount in investments is enough to cover the emergency to begin with.
