Emergency Fund Fundamentals, Benefits & Unconventional Uses

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The establishment of an emergency fund is one of the first recommendations you’ll hear from a personal finance “expert”.  While you will hear a range of opinions on how much you should stash away for a rainy day fund, the underlying reason for the recommendation is the same.

An emergency fund, or a rainy day fund, is savings you have accumulated to protect yourself and your family from a catastrophe such as losing your job or having to unexpectedly face large expenses such as medical bills. It is an attempt to move away from being one pay check from broke.

How much you should save for a rainy day is debatable and mostly dependent on your own risk appetite.  But for the most part you will hear people say that you should have at least six months worth of your expenses saved in an emergency fund.

Six months is a good place to start, and in my opinion should be increased in tough economic times when corporations are downsizing.  You can always release some of the cash from your emergency fund when things start to look hunky dory again.

But why six months? There is really no good reason except one financial expert heard another say it and repeated it and soon the message spread across the industry. Realistically, this number should be whatever it needs to be to give you the comfort and peace of mind you need.

Do You Need an Emergency Fund?

Generally yes. Most people are on a single stream fixed income, often their paychecks from their jobs. For those individuals, an emergency fund is critical.

However, there is another group of people out there who have multiple streams of income. For this group, though an emergency fund is important to have, it is not as critical as it is for someone who will be financially handicapped if they lost their job.

Most financial advice around drawing up a budget plan and saving cash along the way often assumes a single stream fixed income case. An individual should take into account total cash flow from all sources, while conservatively estimating cash from variable sources; In other words, amounts that fluctuate from one month to another.

Having more than one income stream significantly mitigates unforeseen financial catastrophe. The more the income streams, the less critical it becomes to establish a rainy day fund, especially a large one that ties up a significant enough amount.

Because excessive funds tied up in an emergency fund come with opportunity cost, additional income streams allows an individual to best utilize this cash on extraordinary opportunities that may cross their path without having to think too much about depleting the fun or replenishing it in the future.

Many readers of this blog are entrepreneurs of sorts.  Though many of them have successful careers, others do not and solely depend on variable income from one or more sources.  Those not on fixed income need to instill a strict discipline in saving toward an emergency fund at least until their income streams become significantly sizable and diverse.

Other Uses of Emergency Funds

The point behind establishing a reserve fund is to be able to access the cash when in need. Personally I like my cash in high interest savings or checking accounts, or fixed deposits / certificates of deposits that do not penalize to a point where I may end up getting less than my initial invested principal.

These are all liquid investments, or avenues from where I can access my cash relatively quickly and easily. Always ensure the institution is insured, such as FDIC protection on deposits up to a certain amount.

Having the cash accessible at all times also ensures you can quickly seize interesting opportunities that cross your path, such as purchasing the foreclosed home at a 75% discount, or investing in a significantly undervalued stock.

Many tap into their emergency funds to purchase a business or sustain their lives while they work on their start up.  Taking a sabbatical from work to work on your business is a common approach to starting up businesses. However, you need an emergency fund to feed you and pay the rent while you work on your start up.

Then there are those who would eventually like to cut part or all of their insurance policies because they have enough stashed away to the point where they are “self insured”, or able to sustain a financial loss / catastrophe with their own / saved funds.

Concluding Thoughts

So do you need an emergency fund? Yes you do. How much of it depends on your ability to generate cash flow when in need and your personal risk appetite. When in doubt, think of the amount you need saved up in the bank to give you the peace of mind to conduct day to day business with no financial stress.  Peace of mind is often underrated, and achieving this alone will significantly help improve other aspects of your business and life in general.

In addition, an emergency fund can be a mechanism through which you can position yourself to take advantage of opportunities such as the significantly undervalued stocks of 2008 or real estate during a great recession.

Before concluding, I’d also like to throw in the fact that an investment account like a Roth IRA can also been seen as an emergency fund.  Many don’t know or forget that your contributions to a Roth IRA can be removed tax and penalty free at any point (only up to the amount you have put in).

I realize that this topic is relatively basic, and far too ordinary for financially savvy individuals who read this blog. However in the interest of those who may be able to benefit from this information, I hope I have done a fair job of articulating my two cents on this topic.

Readers: Do you have an emergency fund? How much have you stashed away? Why?  Are you prepared to mitigate risk from financial uncertainty?

Sunil
Prepared

12 Responses to “Emergency Fund Fundamentals, Benefits & Unconventional Uses”

1. Jamie Hollister says:

   January 3, 2012 at 3:51 pm

   Everyone should have an emergency fund set up in case of a emergency. Unfortunately, if you are living paycheck to paycheck this is not an option.

   Reply
   • Sunil says:

     January 4, 2012 at 5:16 am

     Welcome to the blog Jamie. It’s certainly more challenging. Can you provide your perspective on how someone barely making ends meet can start stashing cash away for emergency?

     Reply
2. SLee says:

   January 4, 2012 at 7:47 am

   I had six month’s worth saved for quite a while, but I fell in love and forgot that I needed to save that money for a rainy day. Shortly after I got married, I was laid off for a few months and then my wife was (and has been) out of work for a while. We haven’t been able to make much progress in rebuilding that fund yet.

   To answer your question to Jamie, I think that the most important thing is very simple, but it is foundational to personal finance:

   Spend less than you make.

   Even if you are in a situation where you’re living paycheck to paycheck, if you can save some money from each paycheck, you will be able to slowly build your savings.

   Reply
   • Sunil says:

     January 6, 2012 at 4:58 am

     I am sorry to hear about what you had to go through Stephen, but I can see the discipline and determination through your words. I am sure you both will be fine.

     I agree that spending less than you make is fundamental to basic personal finance, but do you think even the lowest earners are in a position to put something away each month? Sometimes I feel it’s easy for some of us to say that relative to the ease/difficulty of execution, no?

     Reply
3. Ann says:

   January 5, 2012 at 9:36 am

   Hi Sunil,
   Hope you had a wonderful celebration for new years! I think your article should be required reading for all children from 6 to 12th grades. We should all have a contingency fund, period! If people had been better prepared, the credit card companies would not be such ‘fat cats’ today. If you save when you are young (and can really afford to fly by the seat of your pants), then when you really need to save, it is a well formed habit and easy to do. I’ve always thought of it as a bill that had to be paid monthly.

   Reply
   • Sunil says:

     January 6, 2012 at 4:59 am

     You make some very good points Ann. I know that for me personally financial discipline started at an early age, and I agree that it is the ideal route. Some are late bloomers, but better late than never.

     Have we learned our lessons after the recent few years? What kinds of trends are you seeing in your credit business?

     Reply
4. Krissy says:

   January 5, 2012 at 10:57 am

   This is a really interesting post, I dont have such a fund at the moment but I can imagine the feeling of wellbeing that having one would give. I think that having this kind of backing would make life more enjoyable and I do plan to save around 6 months expensise, however, to stash that much money will take me quite a long time. Living month to month was okay when I was a student but its really time to focus and ready myself for the real world as it will no doubt present me with a few nasty shocks!

   Reply
   • Sunil says:

     January 6, 2012 at 5:02 am

     Welcome to the blog Krissy. The good news is that most of us do not start off with such a fund. It’s a gradual process that takes time, and you seem like you are on that track. Realization is always the first step, execution comes next. Please keep us updated on your progress.

     Please let me know what topics you’d like to see discussed more. Hope to see you around more.

     Reply
5. Stephanie T. Everett says:

   January 10, 2012 at 1:03 am

   Hi Sunil,

   Emergency fund? Huh! I have never thought of that before. Thank God I’m still in the status that don’t need it. But after reading your post I’m so going to get it. 🙂

   Reply
   • Sunil says:

     January 10, 2012 at 5:41 am

     We all need it Steph! Please let me know your progress…

     Reply
6. Roger the Amateur Financier says:

   January 22, 2012 at 2:33 pm

   Ah, the emergency fund. Always a good source of discussion. At the moment, mine is a bit bare; being a grad student without too much income can cause that. I need to bump that up. (I do have pretty healthy Roth balances, though, so if push came to shove, I’m not completely without options.) Building up a better emergency fund is definitely one of my goals, right along with paying down my high interest rate credit card.

   Reply
   • Sunil says:

     January 23, 2012 at 5:05 am

     You sound like you have a great head start relative to your peer group. If you keep it up, you will be able to dive straight into advanced personal finance once you start working as you won’t need to establish an emergency fund to start things off

     Reply