3 Feb 2010

The Myth About an Emergency Fund and Why You don’t Need One

Read any blog, web site or book dealing with personal finances and you are bound to find one or many pages written about the necessity of having an EMERGENCY fund … The advice ranges from few hundret to start with to the equivalent of 6-12 months expenses.

Continue searching and reading comments on this topic and you will soon discover that most people don’t have such a fund and those who try to have one struggle with: defining its size, knowing when to use it, keeping paying into it in the longer run.

And is if it was not enough there are further considerations like: do I pay into an emergency fund or do I re-pay my debt first? Do I have to have it in cash or in one of mine accounts? What is more important my emergency fund or my retirement fund?



For most people to physically save 5, 10, 15 or 20 thousand dollars/pounds/euros on top of everything else that needs to be taken care of (like your pention, debt, education, etc.) is nearly impossible.

Hence this goal is demotivating and destructive. It’s easy to think – “what’s the point of budgeting, saving, planning my finances if I can’t even provide a safety net in the next three, five, ten years time” (fill in the time it will take YOU to save up that ridiculous amount of money)

I vehemently oppose the whole idea of vast amounts of money tucked away in cash or in low interest savings accounts!

I don’t suggest you don’t have any savings, no! I suggest that you break down your emergency fund monster into manageable chunks of money being saved for different purposes, available on different terms and that you substitute some of your possible saving goals with insurance products.

Pictures are better than words, so here is my hierarchy of emergency funds


Cash Flow

Half of an average of your overspend in the last six months – this is something you should aim to have in your account by the end of the month – each month. – Why? Nothing motivates you more to stick to your budget, keep saving, control your spending, etc. then your current account floating above “0”.

In our case it’s about £200.

This one should cover unplanned minor expenses like shoe repairs, speeding tickets, new toaster and alike (I refuse to get anal and plan (aka save in advance) for this minor crap)

Repairs

Look around your house. What do you have that’s likely to break down and is not covered by warranty? (In our case it’s: heating, appliances, water boiler). How old is this stuff? How much do you think it might cost to repair it?

In our case – I’ve estimated £800 (excluding car)

Other Emergencies

That’s the first part of your “truly emergency” fund. Money for larger, unpredictable expenses. This is an area where you would struggle to come up with an example quickly as this pot of money should cover unpredictable and unanticipated costs, nothing else.

I hope to save here £1500

Long-term Fund

That’s the one that should help you in case of illness and unemployment. To cover for unexpected death I personally opt out for a life insurance. I would estimate 4,000 to 6,000 here.

By the way - the amount you need to save here depends on how many people work in your household now and how many could start working/increase earning if need be. Don't "over-save" just because you don't want to challenge a potential status quo!

Other Stuff

I have an extra car repair saving goal as it is likely that something needing attention will happen each year (latest at the next inspection) and I also have “irregular bills” category in my budget – even if I am paying for something once in a year I can be saving money for it for at least 11 months prior, can’t I?

Where to Get Money From?

My approach to this is quite flexible.

Cash-flow: spending discipline on a monthly basis, I've budgeted for an “underspend“

Repairs and irregular bills: I have listed all irregular bills for the upcoming year and dates they are due - each bill contributes its amount to the overall amount of money saved each month into this category based on its size and due date. Repairs is a rough estimate.
My irregular bills will all be paid by April this year but I will continue to save the same amount of money going forward until I have £500.

Once I've reached this mark I will save for the next year irregular bills and than divert my monthly contribution to the "other emergency" goal.

My "other emergency" and "long-term" both receive equal amount of money (£100 each). That's not much but the idea is to contribute more when additional money becomes available.

The worst possible scenario of a sudden death is covered by a life insurance.

The only vulnerability we are not prepared for is the long-term sickness/disability... I'll worry about this one later. But right now I am considering different options and in particular I am thinking about taking out income protection and life insurance for me and my husband.

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6 comments:

PennyF said...

Hi,

Great post. I agree that breaking down your spending into chunks, by category, makes a lot of sense, and is a lot easier to manage than thinking in terms of one huge sum. It is a good feeling to know that you're making provisions for your once-a-year bills, or a car replacement, and to be able to monitor your progress.

Penny Farthing

http://pennyfarthingfinance.blogspot.com/

Anastasia said...

I found the hardest bit is to make provision for the long-term stuff... like "what if I die"
I am looking into a lot of different types of insurance products but still quite apprehensive about buying one:-)

CJ Bowker said...

I like your concept but I can say I buy into it 100%. Just because people are unable to save doesn't mean they don't have to. There definitely has to be a better way. If your system works for you, great. For someone else it might be different. I think the key is finding the right system for success.

Evolution Of Wealth said...

Liquidity. You might have missed the key to an "emergency fund". Whatever name you give it the money must be liquid. A lot of people make the mistake of getting their money tied up in retirement plans, 401ks and their house. Then when something goes wrong it becomes a compounded problem because of penalties and the trouble they have accessing it.

Anastasia said...

@ CJ Bowker

I find that if I have a goal that feels totally out of my reach I stop pursuing this particular goal as well as several others - so the end effect is much more devastating than just not pursuing or not accomplishing a single goal. Hence, I think it's better to have goals you are likely to achieve and stick to them rather then aiming for something that will end up discouraging you. "Oh so I must have £20k of an emergency fund… and I need to save for my children's school payment, and I need to save something for my pension … and… oh, we haven't been on a holiday for two years now, and there all this debt that I should be overpaying … I only can spare £100 a month towards the emergency fund so it will take me ridiculous 15 years to get to the 20k I need, but by then my earnings would have changed and I am likely to need even more! " By now I feel really miserable and am quite likely to abandon most of my long-term savings altogether… But again, it might be only me:-)

Anastasia said...

@ Evolution of Wealth
Agree - emergency fund must be liquid! I hope to have several thousand pounds very liquid in instant access saving account BUT for the real emergency (long-term illness, death) I would strongly advocate for an appropriate insurance product rather than savings. Anything less than long-term illness (and obviously death) is not really an emergency... Unemployment is only an emergency if you are a single income household, if you can't reduce your bills quickly and if the economy in your region is in really big trouble. But even than - if you have really big loans (like mortgage) and you are concerned about possible unemployment why not take out a payment protection plan?

I'd rather use my money to invest into pension plan as well as save for my new house deposit and children's education ...

There are way too many competing saving goals and with the limited resources I have they need to be prioritised! Spreading savings contributions too thin may be worth than not saving at all...

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