The Dilemma of Emergency Funds - and how to solve it

I don’t think anyone can deny that emergency funds are beneficial. If an unexpected expense occurs or heaven-forbid you lose your job, having money available to use is extremely valuable. But for many folks, especially those who are younger, building an emergency fund, one with 3 to 6 months of expenses, can take many months or even a full year to obtain. The time it takes to save up for an emergency fund has a hidden cost.

Money you set aside in a savings account (to build an emergency fund) is losing value day-by-day in a savings account (due to inflation) and it also isn’t growing (because it isn’t being invested). The opportunity cost or hidden cost of building an emergency fund is the difference between the value of the money you have in the emergency fund and the value of what you could have had if you had invested that money in the market instead. Stated differently, stacking money in an emergency fund means there is less money you can use to invest in the market. Although there is no guarantee that money you invest in the market will increase in value, on average, the market tends to go up over time and money invested in index mutual funds (groups of stocks) tends to increase in value over the course of each year. My point? Maybe you would have been better off investing your money instead of stacking it in a savings account to build an emergency fund...

As if this wasn’t enough, it seems the timing of building an emergency fund is off. When we are younger in our careers with lower income and a big need for an emergency fund, it’s harder to save up for one and the opportunity cost of saving this money, instead of investing it, is quite high. However, when we are older in our careers with a higher income, it is much easier to save money for an emergency fund, but the emergency fund is not as crucial (because we are more financially stable and more likely to be able to cover the cost of an unexpected expense with money from our paycheck or money we already have invested in the market). What does this mean? Emergency funds are most useful at the time in our lives they are the hardest to get and less useful when we are better able to afford them.

So what is one to do?

When we need an emergency fund the most, it’s hardest to get. When we need it least, it’s easier to have. It is because of this dilemma that many folks have begun to question the traditional cash emergency fund. Perhaps opening a HELOC (home equity line of credit) from your mortgage makes more sense. Other people state if you can get a zero-interest credit card then what’s the problem?.Or, maybe it just makes sense to invest that money?

When it comes to pure math, many of these ideas make sense. The problem is that when it comes to personal finance a lot of it hinges on our individual behavior not our ability to do math.

Zero interest credit cards give us the ability to quickly purchase things we desire. Although it can be good for emergencies, many people end up using these cards even when they don’t have emergencies. They spend a lot more money than they would have if the money were being taken directly from their checking account or emergency fund. My point? Credit cards make it too easy to spend money we don’t have on things we don’t need. Most of us need less temptation, not more.

Opening a HELOC from your mortgage can be a great option but since many young professionals are just starting out in their careers, they may not even have a mortgage yet. If they do have one, they may not have much equity available to use. Plus, I personally don’t like the idea of putting my house at risk for an unexpected expense I could have planned for in advance (via a cash emergency fund).

Investing the money in taxable accounts via apps like Robinhood gives you the chance to allow your money to grow. However, if an emergency does arise, you’d have to sell your stock in order to use the money and selling the stock creates a taxable event which decreases your profit. Plus, it may take a few days to sell your stock and have the cash deposited in your account.

A Roth IRA seems to give you the best of both worlds. It allows you to invest money and take out your contributions at any time (while leaving your profits in the account) but it isn’t perfect. There is still a chance the market could experience a downturn and if that happens during the time you need your money for an emergency, then there is a chance that you may not have the amount of money you need when an emergency arises. My point? If you invest the money you take a risk that the money could go down in value and having less money available when you need it most is not ideal.

So how do you handle the dilemma of emergency funds?

Should you prioritize saving money in cash or just invest money in the market? The right answer for you depends on a lot of factors like your household income, job stability, monthly expenses, and net worth. If you’re wondering what I, as a senior family medicine resident, heading to fellowship next year, do…I do both.

I keep about $1000 to $2,000 in a savings account, save about $200 a month for large expenses like a vacation or Christmas gifts, then have the rest of my emergency fund money invested in index mutual funds in the market. Most of the money is in a Roth IRA but I do have some money in a taxable account (that I got as stock options from a previous company as a part of their compensation package). I also invest a portion of my income in my work retirement account. I’m pretty risk averse, so once I become an attending physician (and experience an income boost), I do plan to have 3 to 6 months of expenses in cash. My point? The right answer on what to do with an emergency fund may differ for each person, but having a little extra in cash, especially as a resident or person making the median income, is helpful. Just don’t forget to invest a little along the way.

Tell me, what do you think? What are your feelings about emergency funds? Do you have one? How much have you saved? Where is the money located? Have you decided to invest as you save (via a Roth IRA)?

The Benefits of Having an Emergency Fund

If you’ve ever listened to Dave Ramsey or ventured along the journey of personal finance, you’ll hear a lot of people talking about the importance of an emergency fund. An emergency fund is money that you have readily available, usually in a savings account, in case you incur some type of emergency or unexpected expense. If the air goes out in your home, your car breaks down, or heaven forbid you lose your job, you can quickly access money in your emergency fund to cover expenses.

Many folks have found emergency funds to be quite useful. We can’t always predict when we will incur various expenses but most of us know that they will inevitably occur. Emergency funds help lessen the shock. If the brakes need to be replaced on your car or your iphone stops working, yes you may be annoyed and inconvenienced, but with an emergency fund, the expense itself stings a little bit less. When you know you have money to cover the costs, you tend to be less stressed or bothered by these unexpected expenses.

Is an emergency fund necessary?

For those of us who are still building wealth or who may be 1 or 2 paychecks away from being unable to pay our bills, then yes. An emergency fund is necessary. If we are going to build wealth or at least become financially stable, we have to minimize our need to take out high-interest consumer debt, like credit cards, when expenses arise. One way to do that is to save money in advance, via an emergency fund.

How much do you need?

Like a lot of things in finance, it depends. How much money do you already have saved or invested? How reliant are you on your paycheck to pay your bills? How stable is your job? How consistent is your income? Do you spend most of your paycheck or do you frequently have money left over?

The general rule of thumb for young professionals is to start with $1,000. $1,000 is usually enough to cover minor car repairs, a new phone, a laptop, or a last-minute flight home. As prices have risen lately, perhaps $2,000 is a more accurate number. Regardless, the point is to start off with a reasonable amount to cover expenses and unexpected costs.

The next step, and where most people land, is to save up 3 to 6 months’ worth of expenses. Notice I said months of expenses, not full paychecks. You need enough to cover you in case you lose your job unexpectedly, have to quit, or get laid off. The importance of having this type of emergency fund was ever so present in March of 2020 when the world shut down from the COVID pandemic and even folks with stable jobs, like doctors, were forced to take pay cuts or close their clinics for months at a time. Having money that you can tap into during unexpected times like this is key. The exact amount is up to you.

How do you save up this money?

Unless you have an extremely high income, it may take time to save up this emergency fund. And that’s okay. Most people have to save money from several months’ paychecks in order to reach their desired amount. When I first started my emergency fund, I wasn’t making much money and I was always tempted to spend that money on something else. In order to prevent that from happening. I had a certain amount from each paycheck deposited into an entirely different checking account. I used some of the money in that separate account to pay down debt and left the rest of the money in the account to build over time as my emergency fund. Before I knew it, I had saved $1,000. It increased even more from there.

To summarize, emergency funds can be quite useful, especially when you are starting out in your career. Having money to use in emergencies prevents you from having to take out high interest credit cards when expenses occur unexpectedly. Tell me, have you started saving for an emergency fund?