People often ask why I recommend that their first financial planning priority should be an emergency fund. The answer is that “life happens.” There is always an unexpected expense that pops up. Maybe it’s a fender bender. Maybe the air conditioning on your house fails. No matter, there is always something.
For families without an emergency fund these surprise expenses usually go on the credit card. Usually, the credit card charges double-digit interest rates. So, a $700 expense may end up being an $1,100 expense by the time you pay off the principal amount and the interest. This is process competes directly with a family’s goal of moving forward toward financial goals. So, a bit of cash at hand to cover the unexpected, but completely predictable expenses is super valuable to your financial success.
How Do I Calculate the Amount of the Emergency Fund?
Experts vary in their advice about how much emergency fund is enough. Generally, more is better. Here is a common guideline:
- Determine the amount of monthly expenses that are absolutely necessary. Think of all the things you would need to pay even if you were our of work.
- Multiply the monthly expense total by six to provide a pool of cash to cover necessary bills for six months.
- If your job is especially volatile, or if you are highly specialized and it would talk a long time to find a suitable position, increase the multiple from six to 12.
- If your income is super stable, say from Social Security or a pension, then you can reduce the amount a bit.
Where Should I Invest My Emergency Fund?
Remember, an emergency fund is “insurance” against an unexpected expense. You want the money quickly and easily so you can pay cash. So, this money is not “investment money” this is “insurance money".
Therefore, I recommend that you keep your emergency fund in a savings account at the bank where you keep your primary checkbook.
- It will not cost you anything to keep the account. It might pay a modest interest.
- You can quickly access the money and move it to your checkbook to pay the bill.
- It’s at a bank and so it’s safe from loss.
For some families the emergency fund can be $50,000 or more. Often it’s pretty uncomfortable to have all that cash in a savings account that today is paying about 0.5% per year. In those cases I sometimes suggest the following:
- Keep $15,000 or $20,000 in a savings account at the bank.
- Open a home equity line of credit (HELOC) against the equity in your house that’s about twice as big as your remaining emergency fund need.
- This agreement should be very cheap, or free, to establish.
- The agreement gives you the OPTION to borrow money at a stated rate, usually some percentage over PRIME rate, any time you choose for the life of the agreement, often five or 10 years.
- If you don’t have a big expense and don’t need to use the HELOC there will be not cost and the equity in your house will keep increasing.
- If you do need to use the HELOC,
- you will be getting very competitive loan rates, compared to credit cards, and
- you will be using equity in your home that should be recovered when you sell the house.
Of course, every family situation is unique. If you would like help thinking through your emergency fund options, give me a call. I’m happy to answer questions and discuss your situation.
As a CERTIFIED FINANCIAL PLANNER™ professional I’m highly trained and experienced helping families create a holistic approach to their financial goals. I always work as my client’s advocate – a fiduciary advisor. And I get paid by clients via advisory fees.
A fiduciary, fee-based, CFP® professional can help you make great retirement income choices and develop a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at firstname.lastname@example.org. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.