What most get wrong about Emergency Savings

We talked about emergency savings in the last couple of posts, or rather, briefly touched on it. One of the first questions that comes up in speaking with people about it is this:

"If I can access funds like a credit card, why have emergency savings?"

Borrowing money has a cost! If you are having an emergency, does adding to the expenses sound like a good idea?

I will talk about this until the heat death of the universe.

An emergency savings can keep your plan on track when the unexpected happens. There will always be events in life that pop up unexpectedly. Very often, especially when starting out, these events surpass the income you make in a month.

You might think of the relation between your emergency savings and your plan as something like this:

Let's say you're trying to get in shape, working out consistently, and doing the right things, but then you go on vacation. You were doing great with your workouts until you went on vacation ( or maybe it's just me). Your savings are in the hotel gym, which you could have used on vacation if you had the foresight to bring gym clothes ( again, maybe just me). It's a tool to help maintain your financial discipline.

What things should your emergency savings cover?

Obviously, you want to use your emergency savings for everything, but they should be reserved for events like car breakdowns and sudden medical expenses.

Maybe you've broken your leg, and there's a deductible on your insurance, or you have to fight with insurance for a while before they compensate you. Maybe something happens to your house, and they reimburse you only once repairs are done and in the meantime you're coming out of pocket. If you have the misfortune to put your pet down, or if they break a leg, all those things are in the realm of what emergency savings should cover. You shouldn't use it for a big purchase such as a new TV.

You shouldn't use your emergency savings for a TV on sale at Walmart, a new lazy boy chair, or a vacation. Those big purchases, specifically those wants, should have their own funds that you have set aside for them. Your emergency savings should be for unexpected and sudden needs.

Do not steal from yourself. Unfortunately, I see this quite a bit.

People generally feel that they need savings, and perhaps they will have savings set aside and even contribute to it. Sadly, they also commonly muddy the water by using it for purchases that should have been dealt with otherwise, like the TV or vacation, and that's why I think the term emergency savings is so crucial. If we're saving and then stealing from it every time we are hit with an urge to buy, then it's not really savings. It's now a fund for whimsical purchases, which is fine but should be a separate thing.

Emergency savings are a planning tool. They are not something that you just take from whenever you get the urge. If you want to buy a big want, you should put money aside for it in its own right. Even if you don't have something designated for it, you can put aside an amount each month dedicated to your shopping urges. We are so battered by sales, new tech, and big living that it becomes hard for people to separate need from want.

Emergency savings are only for needs.

With that rant over, how do we determine an amount for your emergency savings?

A good rule of thumb is 3 months of expenses if you're single or are married with dual income and no dependents. Maybe you get a pension from a previous job plus your new job's income. You should save 6 months of expenses if you are married with a single income or have dependents such as kids. The general idea is if you have more to support should something happen, you need more put away. If you're a single bachelor, it's not a big deal for you to sleep on someone's couch during hard times. If you're married and have kids, you need time to get back on your feet if you lose your job or anything else.

Then, you want to reduce the monthly expenses to those necessary. What do I mean by necessary? You don't want to include savings contributions because if you need to use your savings, it doesn't make a lot of sense to turn around and put that back in until after the crisis.

I mentioned using your savings contributions as an expense in your budget, so remove it from your budget during this time as well. Contributions to your retirement, obviously, in the case of losing your job, you won't be making those contributions. For the sake of the example, let's say you're injured or otherwise temporarily disabled for a while. You don't want to be making contributions during that time. Especially considering you can't take the funds back out of certain retirement accounts without penalties.

You don't want to include "fun" bills, such as streaming services like Hulu, Netflix, or the like, in your calculation. You don't want to include those because you can do without them. We are talking about emergency savings, not slightly rough time savings. You don't want any entertainment subscriptions or the like included in your calculation.

Then what should we include?

You should include your monthly grocery bill, a good estimate of your utilities, your minimum debt payments (getting your car taken probably won't help your situation), that sort of thing.

Ideally, you're debt-free, right? But if you're not, you still have to pay for those things, or they'll be taken. So, in short, these are things that you must pay to maintain your functional environment.

On the other hand, having too many savings, as opposed to none, can be problematic. While this is obviously better than no savings, it's not necessarily the best thing either.

Let's say your monthly expenses are $1,000; I know it's super cheap, but bear with me for the sake of explanation. If you're single and have monthly expenses of $1,000, $3,000 is not a bad emergency savings to have.

However, if you have $40,000 set aside, I applaud you for your discipline, but you need to do other things with that money, or it's just getting eaten away by inflation.

At the bare minimum, you should put it into a money market fund (not a money market savings account!!). You should grow your wealth with any funds over and above your obligations, which include paying off your debts and necessary expenses.

If it's money that you don't need in the present, then you can use it to grow your wealth for the future.

Say you're saving for a new car or some other big want. You could keep saving, but I'm not convinced you shouldn't be doing different things with that money. If you have a target date for buying the car, there are investment strategies that will align with that goal. I would consider doing something like that before keeping a bunch of money under your mattress, doing nothing.

I use the term mattress money a lot because I've heard the saying "cash is king," and it's definitely applicable in some sense. But that cash is only king in the sense of deal making; if you have money sitting under your mattress, it is losing value to inflation.

You want it to work for you. There is critical mass there, too, where the more money you have working for you, the more money you get to work for you, and it snowballs. These are all reasons why oversaving is not necessarily a good thing. There are productive things you can do with your money other than buying things (technically, you're buying securities and bonds, but you get my point).

So, finally, how does an emergency savings protect your plan?

An investment, across the board, does better over longer periods. There are obviously scenarios where the company goes under, but as a general rule, the longer you can make your time horizon, the better the investments will do. When you don't have emergency savings and are forced to liquidate your assets at the wrong time, it reduces your return. Not only could you be paying unnecessary commissions or fees, depending on who your advisor is, but maybe it was a down day for the market, and now you are exposed to a sequence of returns risk.

Your investments will perform better over time if you leave them in the market, so having emergency savings prevents you from tapping your investments to pay for an emergency.

Pulling from retirement accounts has added consequences. If you aren't of proper age or don't do it the right way, you will not only have the 10% penalty but will need additional tax funds! Withdrawing the amount you need from a retirement account might net you 75% or less of the amount you pull, forcing you to withdraw more than you need for the emergency.

Finally, emergency savings prevent the unnecessary use of credit and debt. Usually, these events will surpass your monthly income, especially if you are starting out. In trying to rely only on your income to pay for them, you will likely take on some debt or steal from a retirement account.

In a world inundated by marketing campaigns telling us, "You could be doing this cool thing with this little bit of money," our financial attention is strained. Having some money sitting around feels unnatural, but it's an essential part of your plan. No plan survives first contact, so you want to have something in place to help it along in turbulent times. That's what emergency savings are for.

I appreciate you reading this to the end. If you couldn't tell, I feel pretty passionately about having emergency savings, and I rant about it a lot. Thanks for reading, and I hope you'll visit next time!