It takes as much energy to wish as it does to plan. 

(Eleanor Roosevelt) 

Life happens

One of the silver linings to the pandemic has been its ability to highlight the value of an emergency fund in swift, stark terms.  However, as with many big life and financial lessons, the learning often fades as the crisis recedes or people learn to live with the new normal.  But, the best time to plan is before another crisis hits.  And, the best reason to plan is so you can withstand future crises as they inevitably arise.  So, as sort of a post-mortem (no pun intended), now  is a good time to reflect on the role an emergency fund in navigating life.   

When it comes to an emergency fund, most people are familiar with it; some see the value of it; few a have a sufficient amount of it.  Before diving in too deep, let’s define emergency fund.  It’s essentially a certain amount of cash set aside to address life’s common misfortunes: car breakdown, leaky roof, medical emergency, unforeseen tax bill, job loss, death in the family, etc.  The typical American household has $8,863 in cash.[1] Below is the average cash holding for different age groups.[2]  Where do you fall in the mix? 

 

 

Value of an emergency fund  

Regardless of whether or not you have an emergency fund, it’s important to recount its benefits and, therefore, its value within your financial “toolbox.”

Time:  An emergency fund buys you precious time to process your new situation; research potential alternatives or workarounds; find a viable replacement; grieve a loss.  Ultimately, this stash of cash enables you to make the best decision for yourself and loved ones within a short(er) period of time.   

 

Insurance:  An emergency fund is a form of self-funded insurance that helps prevent an unforeseen inconvenience from becoming a catastrophe.  For example, if your car breaks down, an emergency fund helps you either to fix it or to buy a replacement rather than face the possibility of losing your job due to the lack of transportation.       

 

Interest savings:  Although modern life offers a number of alternative (and creative) ways to access cash quickly, convenience is often costly.  Here are the average annual interest rates charged for different forms of borrowing.  

·       Credit Card: 15%-20% (depending on credit score) 

·       Retirement accounts (hardship withdrawal):  Income tax and 10% penalty on distribution

·       Home Equity Line of Credit (HELOC):  5%   

Unfortunately, in trying to solve one problem, you inadvertently create bigger problems down the line.  Take credit cards for instance.  A interest charge of 15% can turn a $5,000 loan into a $10,000 loan in a 5-year period (assuming minimum payments).  Meanwhile, an interest charge of 5% can double a loan amount over a 15-year period.  Convenience can become very inconvenient sometimes very quickly.  

 

Growth:  An emergency fund offers you the financial and psychological buffer needed to stay invested in the market in order to benefit from the (eventual) rebound, capital appreciation and compounding.  When you borrow or withdraw from your retirement savings account to address personal emergencies or fund living expenses, you temporarily or permanently forego the future growth of your retirement savings.  Seven percent is the average annualized return for a 70/30 portfolio.  A 7% return will double your portfolio over a 10-year period. 

How much to put aside?