I am your shield, I am your sword – Everything you wanted to know about emergency funds

One of the first things that new members of the FIRE community get told is that they should have an emergency fund, also known as a rainy day fund.  Usually a figure of 3-6 months of living expenses gets used as a rough guide as to how much you should have saved. 

Unfortunately there are plenty of people who either can’t or don’t do this, as shown by the fact that over a quarter of the population either wouldn’t be able to raise $3,000 for an emergency or would have to do something drastic to raise the money as per this ME Bank Report.

So what is an emergency fund, what should it cover, how much should you have in it etc?  Read on for all the answers to your burning (dad joke intended) questions. 

What is an Emergency Fund

An emergency fund is the shield you use to protect yourself from unemployment or your boiler blowing up, the sword you use to fight back against medical expenses or car repairs.

Or to be less dramatic, an emergency fund is simply some money which you have set aside to cover various types of emergencies  should they occur.  You might be lucky and never ever have to use it, and this is obviously the ideal scenario.  Unfortunately most of us aren’t that lucky and at some stage we will have to tap our emergency fund.  Pretty simple right?

What expenses does it need to cover?

That’s a very good question.  As I said above the figure that gets trotted out is usually 3 to 6 months of living expenses.  Which is a good starting point, but it’s going to be different for everyone, and there is also a fairly substantial difference between 3 and 6 months.  So what should it be?

The 3 to 6 month figure seems to be based on that being how long it will potentially take you to find another job if you lose your current one.  Which may well be the case if you’re in a job where the roles are pretty standard and it’s not that hard to get another one. 

I view some jobs like nursing or teaching as being fairly standardised (I could be wrong on this) where you could just go from one hospital or school to another if you had to for whatever reason, and I know plenty of people who have done exactly this.  Sure there’s going to be a lag particularly around school holidays for the latter, but there is generally a reasonable chance of being hired again sometime soon for much the same money or at least picking up some supply work.

There are plenty of other jobs where this just isn’t the case though, and you might want to set aside more money in case you do get laid off.  When I worked overseas I used to specialise in a very niche role, and by niche I mean there are maybe 250 people worldwide who do it and they all work out of 4 or maybe 5 cities globally.

None of those cities are in Australia unfortunately, so when we moved back to Australia for family reasons I had to retrain into a different career.  Retraining takes time and costs money, but fortunately we had plenty of money set aside so that we didn’t have to worry about how to pay the bills etc.

That’s a fairly extreme example obviously but there are plenty of other jobs where there are only so many roles available because it’s a specialised area.  The more you earn the more likely this is that this is how the hiring market in your job works, in which case you want to have more money set aside in case you lose your job for whatever reason.

Another issue here is that the time when you’re probably most likely to be laid off is in a recession, in which case that 3-6 months can easily blow out to a year or more.  Again, this is something that happened to me when I was living in the UK where it took me over a year to get a new job, I talked about it in a bit more detail here.

So personally I would say that people should have at least 6 months worth of living expenses (not income, although the two are often one and the same unfortunately) in an emergency fund to cover your costs in case you don’t have anything coming in.

There are plenty of other things which you might need to cover from an emergency fund as well.  This includes stuff like:

• If you’re a homeowner replacing a hot water system if it blows up or other home repairs for stuff that isn’t covered by insurance
• Repairs to your car if it has a big issue or maybe even enough to replace it if the problem is bad enough
• Medical expenses
• Replacing white goods like a fridge or washing machine etc if they blow up
• If you own a rental property you might want to have a separate amount of money for that as well to cover repairs or just if the property isn’t tenanted for a while to get you through

Obviously if you’re going to have enough to cover each and every one of these expenses as well as your 3-6 months of living expenses you’re going to be looking at a decent chunk of change.  Which leads to the next question…

How much should be in my emergency fund?

That’s really going to depend on your personal circumstances.  If you’re in your early 20s and still living at home with Mum and Dad and in a fairly standardised job then your actual living expenses may well be pretty low. 

You don’t need to worry about any house repairs or white goods blowing up because they’ll take care of that, you’ve hopefully got a pretty basic cheap car so replacing it wouldn’t cost much, and you almost certainly don’t own a rental property so you don’t need to set any money aside there.  In which case you can maybe go with that 6 months of living expenses and enough to replace a cheap car and you’re likely all good.

If you’re an early 40s homeowning Dad who is the sole income earner with a wife and two kids at home and in a specialised job where it would potentially take quite a while to get a new one, then you probably need a bit more set aside.  And yep, that’s me.  On the plus side I don’t have a mortgage so my living expenses aren’t as high as they are for a lot of other people, but at the same time they still add up to a decent chunk of change as I talked about here.

I’ve also previously posted about how there is only so much that you can cut your living costs in this post and said that I couldn’t get below $30,000 a year without sacrificing something important to myself and my family.

What that means in real terms is that I need a minimum of $15,000 just to cover fairly basic living expenses for 6 months.  Then on top of that I might want to set aside another $5,000 for emergency home repairs like replacing a boiler, another $2,000 or so for medical expenses that aren’t covered by my private health cover or Medicare, $1,000 for white goods blowing up, maybe another $2,000 for car repairs (our car is still under warranty and will be for a while) and pretty quickly I’m up to $25,000 or so. 

Some of these expenses I could and would probably pay for out of cashflow or at least defer for a month using a credit card, but it really depends on what the issue would be.  And if they all come at once, and particularly if I’ve lost my job at the same time, well it wouldn’t be fun time in the HIFIRE household.  Which is why I actually have even more than this in our emergency fund. I’m a safety first kinda guy!

Obviously there are a lot of different scenarios and I’ve only outlined two of them, but what I would recommend people do is have a look at how long they would likely take to get a new job in a recession type scenario and use that as a guideline for how many months of living expenses they need to set aside, subject to a minimum of 3 months. 

Then on top of that add on all the one off costs that could occur like home repairs, car repairs or replacement, white goods, medical expenses etc.  In a lot of cases that’s probably going to be at least $10,000 or so in total. Maybe more if you’ve got an old car that’s not under warranty and that you would need to replace if it broke down.  If you own a rental property add on more again for any emergency repairs over there that wouldn’t be covered by insurance.

Where should I put the money?

There are a few options for where to put the money, these being a high interest savings account, a mortgage offset or redraw account, or just invest it in the market.  I could write about why the market is an option but given Dan at Ordinary Dollar has already done the work for me I’m just going to link to his article here.

I love Dan’s work generally but as you can see in the comments this is one area where I disagree with his conclusion.  I could reinvent the wheel but what I wrote in my first comment there covers my thoughts pretty well.

“I want an emergency fund to give me easy access to cash for whatever purpose I need it for. I don’t want to be worrying about what the market is doing, I don’t want to be thinking about what CGT I might have to pay, I don’t want to potentially be selling shares at a loss, I want cold hard cash right there and then with no delays. I understand that I’ll be paying some tax on the earnings but that won’t be that high anyway, and in any case that’s a pretty low price to pay for the certainty of knowing that I can get access to the money when I need it.
This is particularly important with the second situation you’re talking about where you lose your job during an economic downturn. The last thing I want is to have no income from work AND have to sell more of my shares because they’re worth less in order to cover my living expenses.
I’m not worried about the upside I’m missing out on, I’m focussed on the downside I’m preventing or mitigating by having cash available when I need it. Sure there is an opportunity cost but I’m more than happy to pay it.”

Bearing this in mind I would first and foremost be using a mortgage offset account if I had one (maybe not now, see below new paragraph) or as a backup a HISA (which is what I use).  Yeah, maybe I can get more money if I put it in the market but that isn’t my number one priority here.  This isn’t to say that Dan is wrong, just that we each have different thoughts on what we want our emergency fund to be doing for us.

Edit: Apparently if you use a redraw account with some banks and potentially offsets as well, the bank can decide that if it wants to it can apply the money in the redraw to your loan. So if you had a $250,000 loan outstanding and $50,000 in a redraw so you’re only paying interest on $200,000, the bank can decide that it wants to apply the redraw to the loan so the amount of the loan outstanding is just $200,000. In which case if you needed that $50,000 for an emergency, it’s no longer available. See this story here.

Why can’t I just use a credit card?

Well first and foremost you can’t pay your mortgage or rent with a credit card.  Or more accurately you probably can but the interest is going to be a lot worse than your mortgage rate in the first case, and you’ll be doing a cash advance for the second one which has pretty scary interest rates as well.  That’s a big part of the living costs for most people and would eliminate it straight away for me.

If you don’t have a mortgage or need to pay rent, maybe it becomes more of an option but again it depends on the scenario. If it’s just paying for car repairs, sure no worries. If it’s buying a new car, that may be more of a problem. Same deal with covering living expenses if you lose your job. It’s fine if it’s only a month or two, if it’s 6 months or a year the interest bill is going to be pretty horrible. And that’s assuming your credit limit is high enough to cover you.

Should I prioritise an emergency fund or investing or paying down debt?

This is a bit of a tough one as it depends on your circumstances.  I would definitely be prioritising the investment side last, but after that it’s a bit tricky. 

If your only debt is your mortgage, then you can effectively pay down debt and have an emergency fund by putting the emergency fund money into your mortgage offset account.  Two birds with one stone!

If your debt is a credit card or personal loan, assuming the interest rate is over say 5% or so I’d be tempted to prioritise paying that down subject to having $5,000 in an emergency fund.  Once the debt is paid off you can then fund the emergency account properly.  I’m assuming here that if you have this sort of debt you don’t have a mortgage as most people would roll all their other debt into the mortgage.

Can you get rid of your emergency fund in retirement?

I think you can certainly reduce your emergency fund, in particular you presumably no longer need to worry about having 6 months of living expenses in case your lose your job.  I’d probably still want to keep 3 months in there though just in case your income dips unexpectedly, for example if dividends get cut.

You also still need money for the other things like car repairs or replacement, house repairs, investment property repairs etc.  This is particularly true if you hold large illiquid assets like investment properties.  You can’t sell down $5,000 worth of your property to fund replacing or repairing a car so that’s a problem.

It may well be that you feel comfortable that you can cover these out of cashflow, or you’d happily sell down some others assets to cover this (if you have them), but personally I’d rather have the cash available than needing to sell assets.

So you probably still need to have some money in an emergency fund even if you are no longer working.  Not as much, but still a decent amount.

Should I contribute more if there is a recession?

It certainly wouldn’t hurt to do so.  I was reading this recent post from A Family on Fire about how to plan for a recession and Ms FireMum has it as one of her recommendations.  As she says it’s been 28 years since Australia last had a recession, so if you’re under the age of 46 you haven’t had one in your adult lifetime.

Unemployment in Australia hasn’t been much over 6% since around 2003.  Even in the GFC it barely ticked up to 6%, whereas in much of Europe and the US it was over 10%.  So nowhere near as many people lost their jobs in Australia during the GFC as happened in most of the developed world. 

So yes, I would be contributing more to my emergency fund if I was worried about a recession coming, in particular if I was in a role where it’s likely to take a while to find another job if I lost my current one.

What are the benefits of an emergency fund

One of the biggest benefits of having an emergency fund is the peace of mind you get from knowing that if something were to happen you’ve got plenty of money readily available to sort out whatever has happened. 

I read an interesting article recently looking at two groups of people, one with $500,000 invested in the market including $25,000 in an emergency fund, and the second group with $1,000,000 invested in the market but no emergency fund.  Despite having only half the amount of money invested, the first group were actually far more comfortable with their financial situation than the second group.

Another benefit is that you can have a longer benefit waiting period on your income protection insurance.  Given this is normally the most expensive types of personal insurance, and increasing the waiting period reduces the waiting period by quite a bit, this can easily save you several hundred dollars a year.  That’s money which can go towards your investments or mortgage instead.

The big benefit for me though is really peace of mind.  I don’t worry about money much, and in part that’s because I know that if something were to go wrong financially that I can immediately get my hands on a pretty decent chunk of change and just throw money at the problem until it goes away. 

What are your thoughts on emergency funds?  If you liked this post and would like to read more like it then please subscribe!