Updated on 10.06.14

Emergency Funds on the Path to Financial Independence

Trent Hamm

One of the first things that’s recommended for people as they start on their journey toward financial recovery is to build an emergency fund.

The reason is simple. An emergency fund is simply cash held in a savings account that you can tap when a life emergency happens – like an unexpected death in the family or an automotive issue – without negatively affecting your financial progress on your debts. You simply tap that emergency fund to handle the issue, fill it back up over the next few months, then keep pressing forward.

However, when you move a lot further along the path toward financial independence, your financial situation changes quite a bit. Usually, you have no outstanding debt (other than perhaps a mortgage). You’ve been saving money in your retirement accounts and have a healthy balance; you may also have been saving money in an investment account or in a 529 for your children.

Do you really need an emergency fund at that point? If so, how much?

To answer this question, there are two concepts that need to be explored a little bit.

Cash Flow

The biggest financial difference between someone struggling with a mountain of debt and someone who is debt free (or close to it) is monthly cash flow.

Let’s say you make $50,000 a year, which means you bring home a check for about $3,000 each month. Out of that check, you might have to spend $500 on food, $200 on household expenses, $500 on enjoyment, and another $300 on utilities and other bills, adding up to $1,500.

For a person without debt, that means they have $1,500 each month to spend on investing and preparing for the future. That’s pretty sweet! It’s one of my favorite arguments for getting rid of debt (along with the reduction in personal stress… and the amount of money you’re no longer just handing to the bank…).

On the other hand, a person with lots of debt sees a different picture. They might have two maxed-out credit cards with a $200 total bill, a $300 student loan bill, and a $800 mortgage. That adds up to $1,300 in debt payments, leaving them with just $200 in breathing room each month.

If a $1,000 emergency comes along, the debt-free person can knock it out of the way with their ordinary cash flow for the month. The person with debt? Not so much. That’s why they have an emergency fund.

If you’re looking at the situation solely from the cash flow perspective, an emergency fund, at least for relatively small things, might not make a lot of sense for a person with no debts. An emergency fund for a person in this situation is intended to help with larger emergencies (like suddenly flying your family to Boston for an unexpected funeral) or a simultaneous stack of several smaller ones (like a transmission failure coupled with a flooded basement and a loss of a freelance contract).

Liquidity

Theoretically, a person with great cash flow is going to be doing something productive with that extra money. They’re going to be investing for the future in some fashion, whether it’s through buying real estate, investing in stocks, funding a business, or something else.

Some of those things are going to be very liquid. By that, I mean that the investor can quickly obtain cash from those investments if needed for life emergencies. Money in a savings account is incredibly liquid, for example. You can just stroll down to the bank or to the nearest ATM and withdraw money at your convenience. Stocks are pretty liquid – usually, you can just issue a sell order to your stockbroker and you’ll have cash in a few days.

Other things aren’t so liquid. If you have all of your money tied up in the purchase of a house, for example, you might not have any spare cash that’s easy to tap. In those situations, a short-term significant emergency can cause some serious financial problems.

In other words, I consider it vital that you have some liquid assets at all times no matter what your financial state. You should never, ever have all of your money tied up in something that you can’t sell off within a day or two. If you do that, you’re begging to put yourself in a real financial pinch.

What About Credit?

Some people feel as though they’ve solved this problem by having a credit card with a healthy credit limit or some other line of credit through their financial institution – maybe a home equity line of credit. If something significant happens in their lives, they can simply tap that line of credit, right?

This works fine if you assume a couple of things.

First, you’re assuming that the bank will always exist and always extend this credit to you. If a bank changes ownership or financial direction or re-evaluates the credit they’ve extended to you, they may choose to no longer extend that credit. If that happens, your “emergency fund” has just vanished.

Second, you’re also assuming that identity theft will never happen to you. A pervasive case of identity theft can severely impact your credit and can even cause existing credit cards and lines of credit to close. In that situation, you can be in big trouble if you don’t have access to cash.

People often overlook these constraints because the chance of their occurrence is relatively small. Of course, the chance of most types of emergencies is relatively small. In my eyes, an emergency fund is the one portion of your financial state that should have the absolute minimum risk and choosing to use credit introduces an additional level of risk.

In other words, the purpose of an emergency fund is to protect yourself against the unknown. Emergencies where your credit is denied are certainly part of the “unknown,” but a credit-based emergency fund won’t protect you in that situation.

Of course, if an emergency occurs and you judge that emergency to be one that you can handle with credit without accruing significant interest instead of tapping your cash emergency fund, that’s a personal call regarding your financial state. (This is not a choice I would make if I were carrying a balance on any line of credit or credit card in my name.)

So, What Should You Do?

No matter what your financial situation, I strongly encourage you to have enough liquid assets to cover any significant emergency that comes your way. This is regardless of the amount of credit you have or any other aspect of your financial state.

Having said that, I would still be hesitant to simply call my stock investments or other liquid investments my “emergency fund,” for several reasons.

One, many liquid investments are quite volatile. They can vary widely in value from week to week or month to month. If you find yourself in an emergency, it can quite likely coincide with a big dip in the value of your investment, leaving you short. The best way around this is to have a very healthy amount in that liquid investment.

Two, selling off part of your investment to cover a personal emergency will trigger capital gains tax. If you sell stocks, for example, you’re going to be facing capital gains tax on the profit you earned, which is going to affect your tax bill at the end of the year.

Three, selling off part of your investment will alter the balance of your investment portfolio. You may find yourself exposed to more risk than you’d like… or you might wind up with a more conservative set of investments than you desired.

Four, any assets that you can’t sell locally may be difficult to acquire during an emergency. If a natural disaster hits your area, it is much easier to get some cash out of the local bank than it would be to get cash from a sale of stock through your stockbroker. Some investments are just more liquid than others.

Given those reasons, I still maintain a healthy cash emergency fund. Our savings account always contains six months of living expenses for our family; money beyond that is invested elsewhere. There is almost no emergency that I could face (at least, emergencies that are fixed in some way by money) that couldn’t be solved by having those savings available – and tapping that money isn’t going to disrupt any of my financial plans or trigger any kind of tax bill.

You may choose otherwise, but there is at least some level of risk that’s added by using credit or investments as your emergency fund. It’s a higher level of risk than simply using a savings account at your local bank.

My emergency fund is the one element of my finances where I want to absolutely minimize my risk and maximize my liquidity. I don’t mind not getting much of a return on that portion of my finances. I consider the benefit of minimal risk and very high liquidity to be worth it in terms of how it protects me against personal emergency.

Because of that, I’m pretty happy with just earning 1% in a savings account on that portion of my money that serves as an emergency fund, even though I have plenty of credit and plenty of investments that could step in during a true disaster.

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