Common wisdom in the personal finance world is to have at least 3/4/5/6/9/12 months of expenses in an emergency fund. The money in this fund is used as a cash buffer, not to be invested but to be ready when something bad happens to you. In general, this is really good advice. But for the die-hard FIRE people, do you really need an emergency fund?
Emergency Funds – The Good, Bad, Ugly
An emergency fund can be good or bad, depending on your situation and how you use it. Alas, it can be good, bad, or ugly. I will explore those first and then give you two actual examples where an emergency fund saved me.
The Good – It Saves Your Ass
Emergency funds can save your ass when things go south. In times of crisis, cash is still king. Whatever happens, if you sit on cash you can get yourself out of some pretty terrible situations. Especially when old friend Murphy decides to pay you a visit and everything goes wrong at once.
Imagine you lose your job, unemployment benefits are not paid out for the first month, and then your car breaks down. Oops! Having a couple thousand euros in the bank will be really helpful in scenarios like this one. Of course, you can insure yourself against a lot of scenarios, but readily available cash will definitely help you sleep at night, knowing that if something happens you can pay for it.
The Bad – It Is a Major Cash Drag
Cash drag is the penalty you pay for having cash in your investment portfolio. Since cash currently doesn’t generate a return, and inflation eats its value away, cash is dragging your investment returns down. So having a large emergency fund is hindering your investments, since you could be generating more returns with some of that money in the market.
Especially when you are just starting out on your journey to financial freedom an emergency fund will represent a very large portion of your liquid net worth. If you follow the common advice of first saving up an e-fund, and then start investing, the first year or two of your journey will be spend on building up your emergency fund. Those two years are lost in terms of generating investment returns. Then when you start investing your money into the market, it will take a while to have as much invested in the market as you set aside as your e-fund. Maybe after 3 or 4 years, your emergency fund will still make up half of your total liquid net worth.
It might take a decade or so before your investments will really outsize your emergency fund, but by then, you’ve given up on a lot of potential gains. And maybe you don’t even need this fund…
The Ugly – You Don’t Even Need an Emergency Fund
There are scenarios where having an emergency fund is not necessary. The ironic thing is that people with bad financial habits need this fund the most. They are the most susceptible to having an actual financial emergency, but have the most trouble with saving up a sizeable fund.
Good Financial Habits
On the other hand, people with very good financial habits will find themselves having little trouble saving up a couple months worth of expenses. They might do that within less than a year, because of their high savings rate. If you save more than 50% of your income, it will take you only half a year to save up three months worth of expenses.
However, because these people have such high savings rate, what emergencies can actually emerge that they do need their emergency fund? For these people, saving upwards of a 1,000 euros per month is not uncommon. Maybe they even save 2,000 or more every month. Now imagine that your washing machine breaks. Do you actually need your emergency fund, or can you just pay for a new one out of your monthly savings? I bet the latter…
Alternatives to an E-Fund
Even better, since you have good financial habits you probably know how to float your money through a credit card if you need to buy some time until you next pay check. That means that even if you don’t have the liquidity to pay for something right now, you might have the liquidity in three weeks, so you put it on your card and then happily pay it off when the balance is due without touching your emergency fund.
Even though there are reasons to not have an emergency fund as seen above, I still keep about 4 months of expenses in cash. On top of that, I reserve cash for mid and long-term expenses such as taking vacations (mid-term) and replacing my phone and laptop (long term). That cash is also just sitting in my accounts accumulating. I would say that on average I’m sitting on more than half a year’s expenses worth of cash including the savings for longer term goals. A couple of times, having cash on hand saved me. Below I’ll give you three examples.
1 – That Time the Business Expense Reimbursement was Late
The first example is one that happened to me about a year ago. I used to travel a lot for work, and since I worked in a small company I had to arrange most travel myself. That means booking flights and hotels myself, and then getting that money reimbursed after a couple of weeks – usually at the next pay check. The same thing goes for expenses during the travels, such as meals and rental cars. I just put them on my credit card and get the money reimbursed.
One time, I flew to New York, and I paid for the entire trip using my personal credit card, knowing that my reimbursement would be the next month. The flight and hotel together were around 2,500 euros I believe. Yes, Manhattan is expensive. During that trip I racked up a couple hundred euros worth of expenses, so all in all I was owed slightly over 3,000 euros. The next pay check, that money wasn’t included. Two days later the credit card company took the full balance from my account. Luckily, I had some money saved up. The mistake at work was corrected very quickly, and they paid me the end of the week so I didn’t have to wait until the next month. Still, having a large savings account helped me out here.
2 – That Time HR Messed Up My Tax Withholdings
Just a month ago, at my new job, something similar went wrong. I just work at this place for slightly over six months, and my first bonus was due. It wasn’t a large amount, but still, receiving a pay check that is significantly more than usual always feels nice. This one was too much, it couldn’t be true. Looking at the statement confirmed my feelings, the HR department forgot to withhold taxes on the bonus paid out. Since I live in The Netherlands, the government takes half of a bonus that you receive, and now they didn’t.
I talked to HR, and they said they would correct it next month. The lady from HR asked me if I was ok with that, or that maybe I would want to arrange some kind of payments because it was “quite a large amount” according to her. Luckily, with sound financial habits plus some money saved up I didn’t really care about it. So what, last month my salary was really high, this month it will be low. I kindly thanked her for the consideration but told her to just withhold the taxes in the next month. The amount was slightly less than a thousand euros, so it didn’t really hurt. Plus, I had already set aside the money because I knew one way or another the government would come for it.
Do you need an emergency fund? It depends on your personal situation. I would certainly not invest all of my emergency fund money into the market right now. Therefore I feel like I have too little in liquid net worth to be able to stomach that.
However, if you do have a large investment portfolio, that’s probably over a 100,000 euros, you might consider your portfolio your emergency fund. You can easily withdraw from it when something happens, plus most of the times an emergency is so small you can just pay for out of your monthly savings.
So in conclusion, the smaller your net worth is, the more you need an emergency fund. If you have an enormous savings rate, or a lot of invested liquidity, then I wouldn’t bother keeping on so much cash, since it is a drag on your portfolio.
Do you have a large emergency fund or not?