Understanding the Emergency Fund and how creativity and courage can make this fund work almost seven times harder for you.
There are multiple schools of thought and even debates to one of the great topics of our times, The Emergency Fund.
The “Rainy Day Fund”:
A lot of personal finance experts say you should have a $500 – $1,000 emergency fund that is easily accessible (i.e. a savings account connected to your checking account / debit card) in case of a minor emergency like a flat tire or cavity. I agree and like to refer to this as your “Rainy Day Fund” (RDF), that when accidents happen, you have the ability to withstand that rainy day. Having this account allows for some peace of mind when an unexpected minor emergency occurs. You won’t have to carry a balance on a credit card, or have to cancel a dinner, you have already saved the money just for this purpose. The key thing to remember is, after you spend any of this money, you need to rebuild the buffer immediately! If your original goal is $500, after you achieve the goal, and see it wasn’t painful, continue on the path till you have the full $1,000. The easiest and least painful way to auto-save for this account is to set it up automatically through your bank. If you get paid every two weeks on a Friday, have an automatic transfer set up to transfer $25 or $50 into this account the same day you get paid. If you get paid on the 15th and 30th, do the same thing, set it up to automatically occur every time you get paid. This way you don’t have to see the money or think about it, it automatically moves to the safety net. Now what do you do after you build a sufficient safety net? Stop saving? NO!
The Real “Emergency Fund”:
The second savings account the personal finance experts say you should have, and only after you have the full $1,000 in the accessible “RDF”, is the “Lost My Job / Medical Emergency Fund”. This is the real “Emergency Fund”that they say you should have anywhere from 3 – 9 months of expenses saved. This is a big part of the debate, how many months of expenses should you save? Only you really know that answer. How likely are you to lose your job? How many months would it take for you to get back on your feet? How many months would a major medical issue set you back? So YOU need to decide how much is necessary and achievable, but when in doubt start with 3 months, then work your way up. Notice I didn’t say income earlier but expenses; if you have a $1,000 mortgage, $500 car and insurance, $300 utilities, $200 cable internet, $100 phone, $500 food; that means you have roughly $2,600 in expenses every month. Then using some simple math you can calculate that you need to save $7,800 (3 months) or $15,600 (6 months) or $23,400 (9 months) in a savings account. Similar to the “RDF” you need to make sure that this is an automatic and painless process, every time you get paid, $50 – $200 or whatever you can afford, gets transferred automatically into your savings account. This is where I differ from most of these personal finance experts: my issue with this is the rate of return available on a savings account, even a high yield online savings account only yields 1% interest (maybe a little more maybe a little less). That means that even if you save up the full 9 months ($23,400), you are receiving only $234 a year in interest on this account, which is significantly better than the 0.05% most banks offer on their savings accounts. This is not anywhere near an acceptable return on over $23k!
My advice entails a little creativity, and some courage. Yes having 1 months expenses in a savings account makes sense, if there is a lull in work or maybe some housing or car issues that are more expensive than can be covered by the $1,000 cash fund, you should have some easily transferable money available. The remainder should be invested in an easily accessible personal brokerage account. The reason to have this money separate than an IRA or a 401(k) is those accounts have penalties for early withdrawal before you are 59 ½ years old. There will be a post later on about budgeting and making sure to maximize the 401(k) or IRA benefits. This way if an emergency were to arise, you would have the full 1 month (that you saved in the savings account) to exit your positions and transfer the money into your checking account. This money, we will say the remaining $20,800 should then be invested conservatively but with growth in mind. You never want to have to use this money, but you don’t want to be forced to sell at a huge loss when the market is in a correction (fancy investment lingo for a large movement downward), because that is when you are most likely to lose your job and need that money! Instead you should invest your hard earned money in a balanced fund of some sort that has minimal expenses and meets your risk profile (make sure you understand this before taking any action, ask someone, even me, questions before blindly investing). Purely as an example (this is not an endorsement or a recommendation) the Vanguard Wellington Fund (VWELX) has a 10 year annual return (as of 1/31/2017) of 6.92%, and for comparisons sake, take the $23,400 mentioned in the online savings account section above, 6.92% would be a 1 year return of $1,619.28 (quite a bit more than the $234 the savings account would get you).
Should you wait till you have all of the savings before investing? NO! again. While you don’t want to buy the shares 1 at a time, the commissions will eat into most of your gains, you do want to start the process sooner and allow the gains to build up. You should pick a round number that will be your transfer hurdle number, and every time you have saved that amount up you will transfer it to your brokerage account and invest in the fund (or funds) you deemed a fit for you. Continuing the previous example, you save $2,600 in your savings account, now every time that account hits $3,600, you transfer $1,000 to your brokerage to invest. This will allow you to also invest any interest ($36 a year @ 1%) into the brokerage account as well, thereby compounding your returns.
Things to Consider:
There are risks involved and this money could lose value, you need to consider the likelihood of you needing the money in the near future. If this money is not truly an in case of emergency fund but an “I will probably need this sooner rather than later fund”, you will probably be better off in a savings account with minimal risk and minimal return. If it is in fact a purely in case of an emergency that is not likely, then investing the excess money is the best way to make sure a future $10,000 emergency isn’t one that destroys your life savings. Considering the previous example of investing the $23,400 at a compound annual growth rate of 6.92%, in 10 years you will have $45,688.34, compare that to a compound annual growth rate of 1%, in 10 years you will have $25,848.16. That is a HUGE difference!
Make sure that anytime you take money out of any of your savings accounts, the first thing you do when you are able? PAY YOURSELF BACK! Think of these as loans that you are giving yourself, you owe the money to yourself but don’t have to pay any interest! But the longer you wait, the more you will lose out on earning interest or dividends or capital gains.
Any gains you receive, in a savings account or in a trading account, are taxable in the year you receive the gain. So any interest you receive or dividends, or if you sell a position for a gain, that gain is taxable to the IRS, so be prepared have to pay a portion of any proceeds to Uncle Sam.
Do you have outstanding credit card or high interest loans outstanding? After creating your $500 – $1000 “Rainy Day Fund”, put the extra money you are saving to paying those loans off quicker. The reason it is recommended to create the “RDF” first is mostly psychological, people tend to be less stressed and are better able to handle minor emergencies without compounding the issue with worrying about money. Now why you need to pay off those credit cards rather than investing? Because it doesn’t really matter if you are able to get a 6.92% return or a 16.92% return, if you are paying 26.92% in interest on your credit card. Especially since that credit card is a guaranteed rate year in and year out, while the investments can and will fluctuate. Also, make sure you are doing everything you can to reduce the interest you are paying on the credit cards first (see my article if you haven’t already) then aggressively pay them down with the money you would have used for your savings.
Stay tuned for more Modern Finance!