The Emergency Fund conundrum

For some time, I resisted publishing a blog post on whether one should have an Emergency Fund (or Emergency Savings). First, many blog posts had already touched on that topic. Second, it took me a while to figure out where I stood in this debate.

Until now.

The debate is usually framed in the following way: should one have an Emergency Fund? The easy answer is yes, and most blogs will follow that line of thought.

But let’s take a step back.

What is an Emergency Fund?

An Emergency Fund is an amount of savings set aside to deal with unexpected expenses. Those emergency savings can either sit in a specific account earmarked for “emergencies” or they can form a small portion of a larger savings account. The Emergency Fund could even be cash in a safe at home.

The intention of the Emergency Fund is noble. As human beings, we tend to be overly optimistic, which means that our financial planning can be flawed when dealing with unexpected (financial) hardships. Taking note of this weakness, we decide to set up a tool that will cushion any unexpected blow. To deal with the unknown and unexpected, we have an Emergency Fund. We don’t know how the money will be spent or when it will be spent. All we know is that the funds are here as a shield against what life throws at us from time to time.

Common unexpected expenses include:

• You become ill and need to pay for medical bills;
• A critical household item stops working and needs to be immediately replaced: fridge, boiler, car engine, you name it;
• You get fired and need a few weeks or more to find a new job;
• A family member urgently needs some money and you decide to help out.

Even if you love taking risks, it seems hard to argue that an emergency fund is not a good idea. Those situations could happen to anyone and should, therefore, be anticipated. An Emergency Fund is an easy enough concept for anyone to grasp and seems to be a solution applicable to most situations.

There are also side-benefits to starting an Emergency Fund:

1. No Debt: I vividly remember ads aired by payday lenders on TV. The boiler breaks, the mom overwhelmed with kids and work cannot wait until payday, and a payday lender offers emergency money within a couple of hours so that the mom can get the boiler fixed. This is the worst way of dealing with an emergency. Even if you don’t have anything in your account, you are better off borrowing from friends and family. Set aside your ego to avoid the usurious interest rate charged by those companies. With an Emergency Fund, you have available cash to deal with the issue now. What you spend is limited to the amount required to fix the issue. No need to worry about interest and other hidden fees.

2. Peace of Mind: unless you are a Private Equity investor, most people are reluctant to take debt. Of course, sophisticated investors will love leverage and should take advantage of it (assuming the risks are limited and calculated). But I do not believe this holds true for most individuals. People would much rather pay cash than take debt if they could. When you know that you have an Emergency Fund ready to protect you as soon as something bad happens, you will feel at ease. If you don’t have one, then it is easy to lose sleep on how you will pay for X or Y when it occurs. An Emergency Fund can help you tackle anxiety.

3. Starting Good Habits: an Emergency Fund implies that you start saving to deposit money in that earmarked savings account. If not, how do you intend to deposit cash in that Emergency Fund? Anything that can get you into the habit of savings is beneficial. Once you have reached the savings target of your emergency fund, there really isn’t a reason to stop savings. That’s potentially how you start investing in the stock market or build a deposit for your future house.

Therefore, having an Emergency Fund can be a positive as those side-benefits alone are more valuable than the outstanding balance of an Emergency Fund. Getting into the habit of saving will make you more money than you could ever deposit in your Emergency Fund in the long-run thanks to compound interest. Peace of mind and diminished stress levels will also save you a few trips to the doctor, along with avoiding expensive anti-depressants!

What is an Emergency Fund’s ideal balance?

The next question that comes to mind is how much should you deposit in your Emergency Fund?

Obviously, it depends on a person’s lifestyle, which will determine the type of unexpected expenses one would have to face. If we had to give an arbitrary figure, I would say £3,000 as a bare minimum. With such an amount, you should be able to purchase a new fridge or pay for a few consultations with a doctor. It is also enough to buy a plane ticket to fly back home or to settle a bill that got lost during the summer break.

For others, especially people with children, the bare minimum will be £5,000 or £10,000.

Some people also have emergency savings should they lose their job. Those savings generally cover 3 to 6 months’ worth of expenses. That is generally sufficient time to find a new job unless you live in 2008. This fund – which is another Emergency Fund in disguise – could easily to £20,000 or £30,000. The amount may be even higher if you live in London!

You probably are seeing the point now: there comes a stage where the concept of Emergency Fund becomes a bit meaningless. If you are planning for unexpected expenses and the loss of a job and the cost of medical treatment and then multiply that amount by two for you and your partner, the amount to be saved in that Emergency Fund will simply be enormous. At best, you realize that an Emergency Fund is not that different from a regular savings account. At worst, you are discouraged by the amount required to cover the unexpected, and you give up on saving for your Emergency Fund.

A quick side note on debt and your Emergency Fund

Some people say that you should never use your credit card to pay for unexpected expenses. It is true and it isn’t. So when can you use a credit card in such situations?

• Good use: it is ok to use a credit card to pay for unexpected expenses when you already have the amount to be disbursed readily available in cash in your bank account (whether in a specifically earmarked Emergency Fund or elsewhere). In this case, there is no reason to ignore (i) the points and air miles that this purchase will generate and (ii) the interest (albeit low) that the cash sitting in your account will also produce. In this instance, your credit card is not used in lieu of cash savings but is only a different means of payment. This is fine.

• Bad use(s): pretty much everything else. Using your credit card anticipating next month’s salary to pay for unplanned expenses is obviously a no-no. Resorting to credit when your emergency is a loss of income is probably as bad as it gets. When it comes to an Emergency Fund, there can be no assumptions. It is there or it isn’t. Therefore, you should not assume that you will have the same level of income next month to pay for your credit bill (even if that bill was incurred because of a true emergency).

The fundamental limitations of Emergency Funds

Besides the difficulty of determining the amount to be deposited in your Emergency Fund, there are two fundamental limitations.

First, there is a risk that you will use those funds for non-emergencies. I assume that The English Investor readers will not fall in that trap but not everybody is like you. I fear that most people would use Emergency Funds to replace a broken iPhone screen, or worse, buy the latest iPhone to replace the one with the broken screen. Your Emergency Fund is neither a slush fund nor a Yolo account.

Second, and this is extremely important to grasp, the concept of Emergency Fund lacks ambition. If you need to think of replacing a broken fridge or car engine, you are thinking one item at a time. You risk being uber-focused on the small unimportant things and thus missing the bigger picture.

The problem is that £3,000 does not make a difference in the grand scheme of things. You need to think bigger and take a more holistic approach to your finances. If you want to reach financial independence, you are going to need a lot more than an Emergency Fund in a low-yielding savings account. Remember, when I listed the five action-items to build a financial safety net, I did not list starting an Emergency Fund. This is because an Emergency Fund is not tax-efficient like pensions and will not mitigate inheritance tax like a will.

The reality is that you should not need an Emergency Fund if you have your financial affairs in order. This means ensuring that you have medical and home insurance, multiple savings account with some locked and some immediately available, consistent pension contributions and more.

An Emergency Fund is a great way to start saving. Beyond that, true financial independence and peace of mind will be achieved through a combination of savings and fairly common financial moves such as investing and building passive income streams.