An adequate emergency fund is the most important element of successful personal money management. Yet, it is often mischaracterized and its importance minimized by personal finance experts. An adequate emergency fund provides liquid cash to cover a temporary decrease or interruption in income from a reduction in hours, loss of job, or illness. As such, it provides a sound foundation for personal finances. Without it, budget accounts, targeted savings, and retirement savings are raided during periods of interrupted income. If the interruption lasts long enough to exhaust those savings accounts, debt is incurred to cover living expenses. In the absence of an adequate emergency fund, an interruption in income has the potential to wipe out years of financial progress. That is exactly what happened to many households during the Great Recession of 2007.
Emergency fund misunderstood and minimized by some financial experts
Those personal finance experts who minimize the importance of an adequate emergency fund do not understand the purpose of it. This is obvious from the advice they give. One of the most popular personal finance experts suggests funding emergency savings with only $1,000 before funneling all available money into debt elimination. He assumes that $1,000 will cover most household emergencies such as car repairs, appliance repair or replacement, house repairs, and medical co-pays and deductibles without having to use credit to pay for them. Another personal finance expert suggests funding emergency savings with only $500 before putting all available money into retirement saving and debt reduction. She estimates that amount will cover a car repair or other such expense that exceeds monthly income.
In the view of these personal finance experts, the purpose of an emergency fund is to pay for expenses that exceed monthly income. Those types of expenses are often called unexpected expenses, but they are no such thing. While no one knows exactly when a car repair or appliance repair or replacement will be needed, they do know that they will occur eventually. They are not unexpected, rather they are unpredictable. Unpredictable expenses should be handled through the budget with an amount set aside each month in anticipation of car repairs, appliance repair and replacement, insurance deductibles and co-pays, and house maintenance and repair. The balances in these accounts will grow until they are needed and represent a form of short-term savings. An emergency fund is separate from and in addition to budgeted savings for unpredictable expenses.
How much money does an emergency fund require?
What is an adequate emergency fund? Most experts refer to the average time it takes a person to secure full-time employment and suggest that the emergency fund have enough cash in it to cover basic living expenses for that period of time. The average time it takes to find a full-time job varies with the job market, but cash to cover three to six months of living expenses is often considered an adequate emergency fund. In the immediate aftermath of the Great Recession, many personal finance experts advocated for an emergency fund that covered one year of living expenses. You will have to determine what is an adequate emergency fund for you. In doing so, remember that you lose nothing by allocating too much money to an emergency fund. You can always reallocate some of it to other types of saving accounts or spend some it if you ever feel your emergency fund is excessive. It is better to have saved too much than to find out you saved too little when it comes time to deal with a reduction or interruption in income.
Three months to six months of living expenses represents a lot of money. For example, say a family requires $4,000 per month to cover essential living expenses (food, shelter, debt payments, insurance premiums, transportation, and such). An adequate emergency fund for them would require $24,000 in liquid, short-term savings, or about the price of a new mid-sized sedan automobile. It is tough to advise someone to defer the purchase of a new car or other spending in order to establish an adequate emergency fund. This is one reason some personal finance experts minimize the importance of an emergency fund; they know that most people would rather spend their money, pay down or pay off debt, and save for retirement than set aside cash for an emergency fund. Spending, debt, and retirement saving are issues that confront Americans daily. They worry about them. Most Americans are in denial of their vulnerability to a reduction or interruption of income; they do not perceive it to be an immediate problem.
Households need a stake
All enterprises, including households, need a stake, a cash reserve, over and above immediate income to bridge those times when income is insufficient to meet the budget. Businesses need operating capital. Individuals and families need an emergency fund. Accumulating it is really not that unrealistic if the need for an emergency fund is understood. Say the family in the earlier example above brings home $5,000 a month after tax withholding. The difference between their essential living expenses ($4,000) and take-home pay ($5,000) is money spent on entertainment, vacations, clothing, and similar non-essential expenses. At a 15% rate of saving ($750/month), their emergency fund ($24,000) would have adequate cash in 32 months, less than 3 years. They would have 3 months of living expenses in the emergency fund after only 16 months. Imagine, this family could enhance their financial security dramatically in a little over two and a half years and enjoy it over a lifetime, adding to it from time to time as their living expenses increase.
An emergency fund preserves the integrity of household finances
In the absence of an emergency fund, the only financial security is the next paycheck unless there is a retirement savings account to raid. But what is the point of accumulating retirement savings only to have the account drained to cover a temporary reduction or interruption of income?
Elimination of debt is a worthy financial goal, but there is something worse than being in debt and that is being broke, which is exactly the outcome for people who experience a temporary reduction or interruption in income if they do not have an adequate emergency fund and no retirement savings.
In its role of providing insurance against temporary reductions or interruptions in income, an adequate emergency fund preserves the integrity of household finances including retirement savings. As such, an adequate emergency fund is the key to accumulating the money needed to replace income in old age. It takes both short-term savings (emergency fund and budgeted savings) and long-term savings (retirement savings) to enjoy financial security over a lifetime.
K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages