The topic of “emergency funds” is a hot topic of debate among those pursuing Financial Independence. Some such as the Dave Ramsey advocate that you keep 3–6 months worth of expenses in cash in case of emergencies such as a job loss or leaky roof. While other’s advocate you don’t have anything in an emergency fund and focus entirely on either paying off debt or investing in assets that will help you grow your wealth.
Personally, I don’t have a hardline position on the emergency fund question, but here are five important questions you should ask yourself before you determine how much to stash away in your emergency fund
5 Questions To Ask Yourself Before Determining The Size of Your Emergency Fund
1. Do you Have Credit Card Debt?
Nothing will ace your financial future like hanging on to high-interest credit card debt for an extended period of time. If you have a high balance of credit card debt that you are paying 20% or more in interest, most financial experts agree that addressing that should be priority #1.
If you own your home you might be able to consolidate that credit card debt and greatly reducing the interest you pay by refinancing your mortgage or opening up a home line of credit. Some banks might offer you a non-secured consolidation loan to pay off your credit cards and “consolidate” them all into a single monthly payment with a lower interest rate that is more manageable.
The point is if you have credit card debt you need to address that situation because having high amounts of credit card debt in itself is a “financial emergency”.
2. What is Your Current Savings Rate?
How much of your take-home pay are you saving each month? If you are living pay cheque to pay cheque, then you are living in a much more dangerous financial situation. If you lost your job how long would it be before you could not pay your bills? If you currently have a low or even zero savings rate you might want to put an emergency fund near the top of your financial priorities.
Look for ways to cut whatever expenses you can out of your budget and set it aside in an emergency fund. Even cutting out your daily coffee run can really add up to extra savings.
3. Do you Live in a One or Two Income Household?
If you live in a one income household, an emergency fund will probably be a higher financial priority for you. Since all of your eggs are in one basket so to speak, if the income earner in the house suddenly lost their job, there would be zero income coming in. Ask yourself how long could you get by if the income earner in the house lost their job today?
If you live in a two income household, there are a few questions you’ll want to ask yourself:
- How “secure” is each income earners job?
- Could you get by, at least for a time, on just one income?
3. Do you have Other Pots of Cash sitting Around Already?
If you are prone to saving, you might be surprised by how much cash you have lying around already. For example, my wife and I keep lots of little “pots” of money saved for specific things such as vacations, house repairs, income property repairs, and we recently started savings account to smooth our income for when we eventually have a kid and Trish will be off on maternity leave. While we don’t consider any of these pots of money as “emergency fund” if one of us lost our job today we would be very glad we have access to that cash. Afterall if we are experiencing a true financial “emergency” we would not be needing our vacation money anytime soon.
4. Do You Have Access to Low-Interest Line of credit?
As I have discussed in the past if you’re not financially disciplined, revolving lines of credit can be dangerous. However, if you have the discipline to not use your line of credit to buy a flat screen TV they can be very useful to help smooth out the ride in a financial emergency. The beauty of a line of credit is that it does not cost you anything to have one, as long as you keep the balance at zero.
Once you have one setup you could withdraw from the line of credit as needed in case of a financial emergency. If you own your home you can typically get a very low-interest rate on a line of credit that is secured against your home.
5. Do you have other liquid assets you Could (and would) Access In an Emergency?
If you have money in non-retirement investing accounts, you should ask yourself could you, and would you be willing to withdraw those funds in case of financial emergency? Most people would probably answer “YES” to that question. However, what if all of your investments are in the stock market and your financial emergency coincides with a 40% decline in the stock market? You would have to lock in a tremendous loss on your investments if you were forced to liquidate your investments because you did not have an emergency fund available to you.
Where do you stand, do you have an emergency fund set up? how many months worth of expenses could your emergency fund cover? Let me know in the comments.
Legal Disclaimer: This post is not intended to be taken as financial advice, it is for educational purposes only. Consult a financial expert and review what makes sense for your individual circumstances before making any major financial decisions