The Importance of an Emergency Fund

In my previous post, I talked about saving any extra money that shows up in your bank account (whether by an increase in income or an unexpected decrease in spending). Personally, I experienced some savings opportunities since I’ve had decreased spending lately with everything shut down.

However, many people have lost their jobs. And with the threat of a recession looming, no one’s job is safe. I’ve spent a lot of time lately thinking about how to balance preparing for future downturns while still investing as much as possible. 

A Recession is Always Coming

I know with complete certainty that the chance of an upcoming recession is 100%. I couldn’t tell you when it’s coming (nor can anyone else, no matter what they may claim), but I can tell you it will come eventually.

It’s basic knowledge that we go through the same phases of the economic cycle: expansion and recession. This happens over and over again, every 5-10 years like clockwork. What goes up, must come down, and vice versa.

If you don’t believe me, listen to one of the greatest investors of all time, Ray Dalio. He made a really great overview of how the economy works. It’s easy to understand and well worth the 30 minutes. It’s so good that I just re-watch it every so often, as it’s a good reminder that the bad times won’t last. But neither will the good times, so prepare appropriately. 

Prepare During the Good Times

So in good times, if everyone knows that a recession is coming, why don’t they prepare? And if in a recession, everyone knows good times are coming, why don’t they invest to partake in the coming growth opportunities?

For some reason, it seems that everyone expects times to continue how they currently are forever. Everyone always thinks “this time is different.” It’s like your friend who keeps dating the wrong people. When they are in the middle of the situation, they always think this time will be different and it’s hard to be logical. Everyone on the outside can see what’s really going on. Similarly, it’s easy now to see the good times in the 2000s would end with the 2008 recession, but no one could see it at the time when they were in the middle of it.

When people don’t prepare for recessions in the good times, they are essentially making bets on how long the expansion will last. People think they will be able to see a recession coming, and be able to prepare in time. This is gambling and speculation. No one knows when a recession will come, and if you see it coming, it’s probably already too late. 

Think about the COVID-19 outbreak. In February, things were going on as usual and no one was talking about an upcoming recession. Within a few weeks, everything crashed. Stock markets crashed, jobs were lost, and companies shut down. No one had time to prepare for that. If you hadn’t been preparing for years before, it was too late. 

It’s also not attractive to save money during the good times, because it seems like a wasted opportunity. During good times, everyone’s investing and seeing good returns. Everyone wants in on that action, otherwise they feel left behind.

But then the people who have not saved a reserve fund are in trouble when things crash, and they are forced to sell these investments which have now decreased in value. Following this mainstream path is buying high and selling low: exactly the opposite of what you should do to grow your wealth.

Prepare in the good times, because it’s too late in the bad times.

There are two main things I believe we can do to prepare: keep a cash reserve fund, and pay off debts.

Keep a Reserve Fund

Always have an emergency fund with accessible cash. You should have this before you save for anything, invest in anything, or even pay off debts. A reserve fund is to be used for emergencies (not to be dipped into for anything besides that). This is what you will use if you lose your job, or when you’re hit with a large unexpected bill. 

You’ll use this to pay the bills while you search for a new job, or what you use if your car breaks down, or if you’re hit with a large unexpected medical bill. It’s what will prevent you from going into deeper debt when these catastrophes hit. With an emergency fund, never again will you have to rashly go into debt. 

Note I only plan to use this emergency fund for unexpected bills. I budget for expected car maintenance, regular medical bills or prescriptions, tax bills, and car tags/taxes. These are expected expenses and not the intent behind an emergency fund.

Keep Debt Low

The second half of preparing for a recession is to pay off debts. Debts cause recurring bills due every month, which is what hurts you when you lose our job. Debts seem fine and manageable as long as you have your job, but if you get laid off, lenders still expect to be paid. Even if you just decided to move back in with your parents and not buy anything, you still have to make money to pay your monthly debts. 

The less debt payments you have to make, the better off you’ll be during downturns. While times are good, pay off any credit card debts, car loans, and student loans (in order of highest to lowest interest rates). If you want to be really conservative, you can pay off your mortgage as well. 

Consider Scenario 1: Joe makes $5000 a month at his job. Joe saves $1000 of that, and $2000 goes to his various debt repayments (the rest goes to his regular costs of living like food).

And Scenario 2: Joe makes the same $5000 a month, but he saves $3000 instead of $1000 since he doesn’t have the $2000 in debt payments. 

In what scenario is Joe better off if he experiences a layoff? In scenario 2, he could always stop saving until he finds another job, and his expenses are only $2000 a month (which he could probably cut by driving less and spending less eating out or on entertainment). But in scenario 1, his expenses are $4000, because he must still continue paying your debt obligations. 

This is why paying down debt generally makes more sense before investing (although there are exceptions, such as saving for an emergency fund before paying off debt or deciding to invest instead of paying off your mortgage depending on interest rates).

Pay Off Debt or Build an Emergency Fund First?

As I’ve hinted above, you should build some sort of emergency fund before paying off debts. This is because you’ll need some amount of cash on hand to avoid going further into debt. When unexpected emergencies arrive and you have no cash on hand, you’ll have to take on more debt to take care of those emergencies (most likely in the form of credit card debt).

Remember, the first step on the path to financial independence is to create a surplus in your budget. At all costs, you want to avoid going deeper into debt. Having an emergency cash fund will allow you to take care of unexpected emergency expenses while you pay off existing debts. This is why you need to build some degree of emergency fund before paying down debts (even if it’s small). 

How Much Should I Have in an Emergency Fund?

Generally, anywhere from 3-12 months of expenses is recommended. What you choose should be based on your job stability and risk tolerance. If you have a very stable job where you’re unlikely to be laid off, and you have no debt, an emergency fund covering 3 months expenses may be okay for you. 

For most people I’d recommend having 6-12 months of expenses, whatever allows you to sleep at night. 

For some, a blended approach may make sense. Maybe you have a lot of high-interest credit card debt. Because of the high-interest on credit cards (20%+), you may decide to save 3 months of expenses and then aggressively pay off your credit card debt. Once your credit card debt is eliminated, you build up to 6 months of expenses in reserves and then move on to paying down some lower-interest debt like student loans.

Where to Put an Emergency Fund

An emergency fund should be easily accessible, and it should be somewhere safe and non-volatile. This will ensure that you can use it easily if needed, and that it’s not subject to huge swings in value (like the stock market) which could cause you to withdraw while it’s at a low.

But you also shouldn’t hold it all in actual cash, since cash can easily be lost or stolen, and cash will not generate any returns at all. 

You should put your emergency fund in a high-interest savings account. These are easily accessible, but have better returns than a checking account. I have mine in a high-performance CapitalOne360 savings account. It currently earns 1.5% (although in the past it was at 2%). These rates aren’t the sort of returns you want on your investments, but this money is for emergencies, not for investments. You just want it to sit there for when you need it. With 1.5-2% rates, it should about keep up with inflation. And, it’s much better than the 0.2% you’ll get in a checking account.

Limitations of an Emergency Fund

All this said, there is a limit to how much money you want sitting in a savings account. Saving more than a year of expenses isn’t really going to give you much benefit. If you get laid off, you should be able to recover your income within a year, and once you do, you can replenish the original amount of savings that you depleted for emergency use.

After you save up your emergency fund, you can put your money to better use in investments where they could make 5-20% returns (depending where you put it).

That said, there may be other reasons you want to hold cash outside of your emergency fund. For example, you may want to save up for a down payment on a house or investment properties. Or maybe you’re saving up for a car or a trip, which are best to pay for in cash (so that you don’t finance liabilities).

Let me know in the comments what your ideal emergency fund amount is!

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