I’ve outlined my emergency fund approach to a few people and some have called me reckless and foolish. Others have said it is a wise financial decision demonstrating a knowledgeable level of prudence.
I’ll outline my approach here: when it’s smart to have an emergency fund and when it’s smart to reduce the level of that cash buffer. Now I’m curious to see how my readers will weigh in on the, “Are you an idiot?”, debate.
Before we dig in, let me clarify one point: we should all seek to have an emergency fund. Ideally, at least 3-6 months worth of monthly expenses.
I prefer to think of an emergency fund for WHEN we need it, not IF we need it.
We can’t use an emergency fund wisely or foolishly, if we don’t have one to begin with.
A successful buddy of mine in banking said he didn’t need any sort of cash buffer because he had a steady paying job and various types of insurance to cover any type of problem that could come up.
Then one day he stumbled into legal trouble and racked up a four figure legal bill, overnight.
He has since reformed his ways.
We would all agree an emergency fund is used wisely when we come against an actual emergency. There is no controversy in that. The few cases I can think of off the top of my head include a major non-routine repair on a vehicle, a medical emergency, or if we have high interest on credit card debt.
There isn’t much reason to holding cash at ~0% interest if we’re racking up 18-24% interest on credit card debt. Afterall, if we pay down the credit card debt and need to pay for that major car repair, we can charge it on that credit card and be back to square one.
Here’s my emergency fund approach: my girlfriend and I recently came up against the 2015 deadline for maxing our IRA contributions.
We both decided to draw down on our emergency fund to meet the maximum contribution levels.
Our total withdrawal took us from having ~4 months worth of saved expenses (rent & student loans), to only having ~2 months worth.
If we factor in our monthly budget outside of rent & student loans, then the numbers look closer to be as ~2 months to ~1 month’s worth. These numbers are on the conservative side because I would imagine our monthly budget for wine or dining out would be cut if we faced a situation where our incomes dried up.
The risks at play here are clear: If one of us loses our job, we would immediately need to stop all contributions into our 2016 retirement accounts. If we both lost our jobs, then we would rack up credit card debt and we would only have 2 months for at least one of us to land a new job.
We both are covered by insurance, including renters insurance.
I’m not advocating having no cash buffer or not trying to build up an emergency fund. I’m advocating using an emergency fund when we can see a meaningful reward and we can identify the risks at play.
In our case, the IRA contributions saved my girlfriend $1,581.35 on her 2015 tax bill. The payments directly associated with our cash buffer drawdown accounted for nearly 75% of that savings.
First off, this process has obviously involved some stress. My girlfriend does not enjoy seeing our combined cash balances so low. But, the level of stress does not outweigh our combined desire to max out our IRA contributions.
We prefer to think we have no other option.
It makes sense to us, that in order to build wealth in a meaningful way, there would need to be some risks involved.
If it was an easy process, then more people would be financially independent. We do believe it is a simple process, but far from easy.
As for finding a new job, I have a high level of confidence that we would not be unemployed for two full months. My confidence is based on our experiences when we had to find new jobs. I’m also confident, worst case scenario, that my former employer would be more than happy to take me back if somehow my current employer let me go.
They say ‘job security’ is not about how secure our current job is, but how quickly we can find a new one if needed.
Have you done anything similar with your emergency fund in recent years? Do you stick to having at least 3-6 months and never touch it unless it is an absolute emergency?