Factors influencing your emergency fund decision

by Manshu on February 14, 2010

in Personal Finance

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Last week I read an interesting post about emergency funds over at Dough Roller, in which DR states that he has never kept cash stashed away for emergencies and doesn’t plan to do it either.

Here is what he had to say:

Confession time. I’ve never kept 3 to 6 months worth of cash sitting in a bank account and don’t plan to. In an emergency, I can tap investment accounts, a home equity line of credit, or yes, even the dreaded credit card. The question for today is whether it’s a smart money move to rely on credit cards as your financial backstop.

An emergency fund is a sum of money that’s easily accessible, covers 3 – 6 months of your expenses, and is only used in emergencies. Money in your savings account qualifies, but money tied up in stock doesn’t.

Some people don’t like keeping cash in savings accounts for emergencies because of the pathetic returns. Their argument is that the same money will earn higher returns elsewhere, and if there is an emergency, — you can always tap into your stocks, home equity line of credit, credit cards etc.

I used to be part of this camp, but my perspective has changed over the years. Primarily because, when things start to go wrong, everything goes wrong at the same time, and all hell breaks loose.

During the recession — people lost their jobs, the stock market crashed, home prices went down, and quite a few saw their credit card limits slashed too. Even if the limit wasn’t slashed, it must really hurt to pay interest in an emergency. This, in a nutshell is my reason for having a cash emergency fund. To protect yourself from times when all hell breaks loose.

Now let’s take a look at the factors that determine how likely a person is to have an emergency fund.

1. Total savings: This is an important factor when it comes to an emergency fund. If your total savings cover just 12 months of expenses, then it is highly unlikely that you will be comfortable with keeping half of that in a savings account that doesn’t pay much. On the other hand, if your savings are somewhere to the tune of 3o or 40 months expenses, then you won’t mind keeping some cash idle.

2. Job security: If you have a reasonably secure job, like someone in the government sector, then your propensity to think about emergencies will be slightly lower than someone who is used to seeing layoffs around him. As a result, your inclination to keep money idle will be lesser.

3. Fixed expenses: If you have to make a number of fixed payments every month like car loan payment, home loan payment, credit card bills, school fee etc. — then getting into financial trouble is a lot easier than if you didn’t have so many liabilities. Higher liabilities should generally mean that a person protects themselves from emergencies by having some liquid assets.

4. Dual income: A family where both the husband and wife work would feel a lot more financially secure than a family where there is only one earner. I think single income families should be keener on an emergency fund as compared to a dual income family.

5. Personal experience: I see families where someone or the other is always sick, and such families are more likely to appreciate the need for having some cash at hand. Then there are people who lost a job, have their car damaged every month, or have some sort of financial demand on them every other month. Such people are more likely to appreciate an emergency fund, than someone who hasn’t been through many financial hardships in the past.

Personally, number 1 influenced my emergency fund decision the most. As soon as I built size-able savings, I stashed away a certain sum and forgot about it. I have a bright sunny outlook on life, but I have seen several stock market crashes, and layoffs to not worry about a rainy day.

I would hate to make distress sales in the stock market, and a credit card is a tool of convenience for me, and I’d hate for it to become my lifeline.

Think about these factors and how they apply to you, maybe you need to build an emergency fund, but haven’t thought about it.

It is a question of sound finances, but also of mental peace.

Photo Credit: Gilbert R

{ 2 comments… read them below or add one }

Indian Thoughts February 16, 2010 at 3:24 am

I share my thoughts with you here. I myself would rather miss on small interest rather then loosing money in stock market sue to distress sales.

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Manshu February 16, 2010 at 4:48 am

It can feel like paying for life insurance, sometimes it feels like throwing away money, but having the money in times of need is much much more important than saving the few hundreds in premium every year.

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