You’ve been told over and over again that you need an Emergency Fund. However, you find it hard to justify having cash sit and do nothing. Why are emergency funds so important?
An emergency fund is money that is set aside that is immediately available when unexpected costs come along. Immediate and unexpected are key words when describing an emergency fund. It must be liquid, not locked up in investments or other assets that must be sold off before use. And the use of that money is intended for expenses that pop up that you wouldn’t be able to pay off without using debt or selling other assets. Building an emergency fund is not about money, it is about safety, security, and peace of mind.
The 7 reasons below will inform you why you need an emergency fund.
1. We Don’t Know Know the Future
If I were to tell you 3 months from now your car’s transmission will fail. You’ll take it to the auto repair shop and they’ll tell you it will need to be replaced and it will cost you $3,000 out of pocket.
Knowing that in advance, you’d probably adjust your budget and start saving $1,000 for the next 3 months to be able to pay for it.
But guess what?
We don’t get that much time in advance for car troubles.
We don’t know what lies in our future. It is best to be prepared.
Prepared for anything. Emergencies can arise from any situation:
- Auto
- Medical
- Children
- Pet
- Legal
- Home Repair
No matter what the reason for the emergency, its not typically “budgeted”.
An emergency fund will be able to safeguard your bank accounts and monthly cash flow for when “surprises” come along.
2. Recessions, Economic Downturns, and Layoffs
Continuing the theme of not knowing the future, loss of income can come out of nowhere much like unexpected expenses.
Sadly, there may be a day when you are let go from your job. It happens to us all, either by choice, or someone else’s choosing.
Losing a job may be a result of poor job performance or difficult decisions made by management during hard times. This is seen often during recessions, where mass layoffs occur at a single business. You can learn more about recessions in this article, 7 Facts of Recessions for Beginners.
In these cases, there might not be enough time to prepare future funds if your income goes to $0.
How do you pay your monthly bills and living expenses if you have no more paychecks? Even if you get a new job within a month or two, how much debt would you accrue to pay your normal monthly payments?
3. Avoid Debt
While the reasons above all lay out why you should build an emergency fund, it all boils down to:
Avoiding Debt.
Debt is bad because of the interest that comes along with it. You will have to repay the original debt/loaned amount, plus extra based on the interest rate.
The interest rate is key. According to a Forbes article on average credit card interest rates, the average credit card interest rate is 24%. Comparing that to the average return of the S&P 500 of 10%, we can see 24% is greater than 10%. Even if you invest and pay debt at the same rate, you’re still losing. *Lots of exceptions here depending on the rate on a loan or credit card.*
By spending time and money on debt, that’ll delay buying assets.
Assets that can build wealth.
By having that emergency fund, you can avoid paying more than you’d have to and delaying that compound effect.
4. Protect Your Assets
It is said that one of the most important aspects of investing is “time in the market”. Meaning, the more time you allow your investments to grow and compound, the greater returns you will make.
Those investments are assets. For a refresher on what is an asset, read my article on how assets put money in your pockets.
If you end up having an emergency, and you’re at a point where the cost of the emergency is greater than your credit limit, How do you pay for that emergency?
In these cases you might resort to selling assets to get cash you need to pay bills.
Or say you lose your job and you need money to pay the rent, bills, utilities, etc. Selling those assets until you find a new job may be the only option.
So what is the main problem with selling your assets?
If you are forced to sell them, you are stopping those investments from growing and compounding. Not to mention when you sell your stocks, any capital gains you have on them may now be subject to taxes.
All that hard work and time spent on growing those assets are now gone.
Imagine spending 5+ years investing regularly into assets, and having to start all over again.
Building an emergency fund will help protect and shield those assets from ever having to be used.
5. Insurance Gaps
Thinking back to my younger self, I didn’t think an emergency fund was important because I had insurance.
Car, medical, renters, homeowners, etc.
If something would happen to my car, my insurance would cover it, right?
Many years ago my wife and I were out driving and got rear-ended. Nothing major, no one got hurt, but it did enough damage to need bodywork. We took it to the car dealership and got it all sorted out, but there was this thing called a deductible. This was my first time hearing about this term.
Turns out, we needed to pay $500 before the insurance would even start to cover the rest of the cost. In my head, I thought “I pay monthly car insurance payments…just to have to pay even more before the insurance actually kicks in?”
Now I’m not poo-pooing insurance, it helps. They negotiate lower rates with health care systems, pharmaceuticals, car repair shops, etc. but not everything is 100% covered.
If insurance does not cover 100% of the cost, how do you plan on paying the rest of that emergency? That’s what an emergency fund is for. If you have insurance that covers 90% of the bill, and the rest comes out of pocket, you’ll be responsible for that extra 10%.
That extra gap left over by insurance could be enough to set you back financially.
Pseudo Emergency Fund – Health Savings Account
I will say there is one other option, other than an Emergency Fund, one can use to pay that insurance gap, and that would be an HSA, Health Savings Account.
Not to go deep into this topic, we can save it for later, but high deductible health insurance plans are VERY common these days. This means, for medical services, you need to pay everything out of pocket up to very large sums, sometimes up to $4,000-$6,000 depending on family size and plan before insurance will pay for services.
If you have one of these accounts, you can get an HSA which is a tax-deferred savings account to pay for out-of-pocket medical services. So kind of like an emergency fund, but for health/medical services only.
For more information on HSAs, this episode of Investing for Beginners Podcast hosted by Andrew and Dave do an excellent job breaking down HSAs.
6. Peace of mind
Those who are living through it or have lived through it, know that living paycheck to paycheck is hard. Hard to sleep at night. Hard to think about the future. How hard one emergency could cripple your daily life.
Having that extra cash just sitting there, acting as a bullet-proof vest ready to save your financial life, makes a huge difference.
It gives you freedom.
Do you feel “free” if you are so tight with your monthly budget because one unexpected expense can ruin everything you’ve built?
When I say “Peace of Mind” as it relates to investing and personal finance, I circle back to the idea of, Financial Freedom.
I wrote an article talking about the Top 5 Reasons Why You Should Invest and one of those reasons was around Financial Freedom. Financial Freedom may be hard to explain, but in the context of emergency funds, having Peace of Mind makes you feel free. That freedom is one aspect of Financial Freedom.
Whether you call it a “safety net” or a “bullet-proof vest”, emergency funds have always been associated with things that will save your life.
That feeling that your life won’t end if some crisis comes along, is the peace of mind an emergency fund offers you.
7. Size Matters
While listing our reasons for having an emergency fund, it’s also important to know how much or what the size of the emergency fund needs to be.
We’ve established several examples and reasons why it is important to have an emergency fund. However, there are a lot of dependencies that will factor in the size of the emergency fund.
- Number of incomes per family
- Are you the sole breadwinner of the family?
- Are there multiple sources of income?
- Size of the emergency
- Is the emergency a car repair? Or a medical issue?
- Was the emergency an additional expense or loss of income?
I don’t want to answer or prescribe a number at this point. But as one starts their investing journey, or is aiming towards Financial Freedom, these dependencies or questions need to be addressed. They can guide your answer on how big your emergency fund needs to be.
Starting from Zero
I want to stress that the most important thing about an emergency fund…is getting started!
Even if you come up with a number, or size of the emergency fund, most of us are going to be starting at $0.
Goals can be as small as $100 per month. After doing this for one year, it’ll be $1,200. After 3 years, $3,600.
Assuming “emergencies” don’t happen that often, 3-5 years of building an emergency fund is doable for anyone!
Summary – Why You Need an Emergency Fund
An Emergency Fund is so much more than money sitting around collecting dust. Its protection, a security net, a bullet-proof vest.
Life will throw you a curve ball. We don’t know when that pitch may come our way, but rather than striking out and going back to the bench, we can get a hit and keep on playing. Keep running those bases, trying to get to our goal of home plate…or Financial Freedom.
The fact is, we don’t know when that pitch will come. Or when that next emergency will come. A broken car. An unexpected medical service. The loss of a job, aka your income. Once we understand that we don’t know the future and don’t know what lies ahead, that being prepared is the next best option.
By being prepared, we can avoid going into debt. We can protect our assets so they can continue to grow. That cash will be available to pick up what insurance does not pay for.
It’s all about being prepared.
Once you start preparing for those emergencies, you’ll get a better understanding of how much you need to save in case an emergency pops up.
These are the reasons why you need an emergency fund.
Thank you so much for reading! I hope this inspires everyone to get out there and start building or adding to an emergency fund.
For more great advice for beginning investors, check out my most recent blog articles or if you need more inspiration to get involved with investing, read my Top 5 Reasons Why You Should Invest article.
Disclaimer
Levelzeroinvestor.com is not a registered investment, legal or tax advisor or a broker/dealer. All investments / financial opinions expressed by Levelzeroinvestor.com are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that all information is accurate and up to date, occasionally unintended errors and misprints may occur.
Great article! Setting aside an emergency fund is so important to one’s overall financial health. The size of the emergency fund does matters and I’m glad you pointed it out! 🙂
Thank you!
It’s hard not to want to rush out and start investing right away, but arriving at Financial Freedom is more than just investing. As you said, it’s about your “financial health”.
Size does matter! We’ll open that can of worms later!