Why the Emergency Fund Comes Before Every Other Money Goal You Have

The furnace does not check your savings rate before it quits. It chooses January, preferably a Sunday, and it sends the bill in the middle of a cold snap when every contractor in the county is booked. Nobody has ever stood in a freezing kitchen and said, "I wish I had less cash on hand."

That small scene is the whole case for the emergency fund, and the case is stronger than it looks. Before you invest a dollar, before you accelerate a mortgage payment, before you start a business or open a retirement account beyond the match, you need a reserve of cash that is yours to spend on trouble. I am going to argue that in numbered premises, give the objections their due, and tell you where to keep the money. This is general information, not advice for your situation. Your income, your obligations and your risks are your own, and a qualified professional can speak to them in a way a blog post cannot.

Definitions

An argument is only as good as its terms, so here they are.

An emergency fund is a reserve of cash held for expenses that are unexpected, necessary and urgent. A transmission failure is an emergency. A layoff is an emergency. An uninsured medical bill, a burst pipe, a sudden trip to a sick parent's bedside: emergencies. A sale on a flat-screen is not an emergency, however urgently it presents itself.

Savings for planned costs is a different thing. It is the money you set aside for a known expense on a known date: next year's property tax bill, a family vacation, the down payment on a house. Those are goals. They have a number and a deadline. An emergency has neither, which is exactly why it needs its own reserve.

Liquid means you can have the money in a day or two, without a penalty and without selling anything at a loss. Insured means that the bank holding it is covered by federal deposit insurance, up to the limits discussed below.

Keep the two reserves separate in your mind and in your accounts. The most common way for an emergency fund to disappear is to be quietly borrowed by a vacation.

The argument in six premises

1. Emergencies are certain in aggregate and unpredictable in particular. Over a working lifetime, every household will face a car repair, an appliance failure, a medical bill or an interruption in income. No household knows which will come, or when. Prudence plans for the category when it cannot plan for the instance.
2. A shock without a reserve becomes a loan. If a $1,800 repair arrives and the household has $300, the remaining $1,500 goes on a credit card, a payday lender or a relative's goodwill. Borrowing is the default response to a shortfall, and the borrowed money has a price.
3. That price is steep and it compounds. Take the hypothetical $1,800 repair paid for on a card at a 22 percent annual rate. If the balance sits unpaid for a year, the interest at that rate is $1,800 times 0.22, which is $396, an illustration that ignores the details of how issuers compute it. The household paid $396 for the privilege of not having saved $1,800.
4. A shock with a reserve is an inconvenience. The same repair, paid from a fund, costs $1,800 and ends. No interest accrues. No credit score is affected. The household rebuilds the reserve over a few months and goes on.
5. Every other financial goal depends on not being forced to abandon it. A household investing for retirement that is forced to cash out the account in a crisis pays taxes and, in many cases, penalties, and often sells at a bad moment. A household paying down debt that has to run the cards back up has wasted the effort. A business owner who has no reserve is one slow quarter from closing.
6. Therefore the emergency fund comes first. Not the only goal, but the first one, because it is the one that protects all the others.

You can disagree with the conclusion only by disagreeing with a premise, and I do not see which one. Premise 3 is arithmetic. Premise 5 is common sense. Premise 1 is a description of life.

How big, and why it is a range

The usual guideline is a reserve of three to six months of essential expenses. It is a range, and the range exists for a reason.

Take a hypothetical household whose essential monthly costs are $4,200: housing, utilities, food, insurance, transportation, minimum debt payments. Not what it spends in a month, but what it must spend to stay afloat. The arithmetic is exact: three months is 3 times $4,200, or $12,600. Six months is 6 times $4,200, or $25,200. The gap between the two is $12,600, and the question is where in that gap a given family belongs.

The answer depends on risk, and risk is a family-specific thing. A few illustrations, all general:

• One steady income, a government or large-employer job, no children: the lower end may be reasonable.
• One income, a family with several dependents: a higher number is prudent, since there is no second paycheck to fall back on.
• Commission, seasonal or self-employed income: a longer reserve smooths the gaps between good months.
• Two incomes in the same industry: the two jobs are less independent than they appear, because one downturn can touch both.
• Home ownership, an older car or health conditions: each adds the likelihood of a large, sudden cost.

Notice what the guideline is not. It is not a law of nature or a precise calculation. It is a rule of thumb that emerged from experience of how long it can take to replace a lost income, and in a tight labour market, three months may be generous, while in a slow one six may not be enough. Treat it as a target to set deliberately, not a number to be handed down.

Also notice that the base is essential expenses, not your whole budget. In a true emergency the vacation fund is the first thing cut. If you have worked out your categories, the essentials are the lines that must be paid, and Give Every Dollar a Job Before the Month Starts, the Zero-Based Budget explains how to separate them from the rest.

Where to keep it

The fund has three jobs: it must be there when needed, it must be quick to reach, and it must not lose value in a panic. That rules out most investments. A stock fund that has fallen 30 percent in the same month you have lost your job is not a reserve. It is a second problem.

The standard answer is an account at a federally insured bank or credit union: a savings account, a money market deposit account or a short-term certificate of deposit with a ladder of maturities. These are boring. That is the point.

The facts worth knowing about deposit insurance are specific. The Federal Deposit Insurance Corporation, created by the Banking Act of 1933, insures deposits at member banks up to $250,000 per depositor, per insured bank, per ownership category. Each of those three phrases carries weight. "Per depositor" means that two spouses each have their own coverage. "Per insured bank" means that the same person at two banks has two limits. "Per ownership category" means that single accounts, joint accounts and certain retirement accounts are covered separately. Credit unions have an equivalent insurance through the National Credit Union Administration. For a household whose reserve is well under $250,000, the practical lesson is simple: put it in an institution that is insured, and confirm the coverage with the FDIC or the institution itself.

Two further practical points. Keep the fund separate from your everyday checking account, ideally at a different institution or at least under a distinct label, so that it does not blur into spending money. And keep it reachable: an account that takes a week to transfer from is less useful in a crisis than one that takes a day.

Building a starter fund when you have nothing

The six-month target is intimidating if you have no savings at all. A household with $0 and a $25,200 goal may reasonably conclude that the project is hopeless. It is not, and the sensible way to begin is small.

1. Set a starter goal of one month's essentials, or even a flat $1,000. The very first dollars are the most valuable, because they cover the most common emergencies: a flat tire, a prescription, a minor repair. In the hypothetical above, one month is $4,200; a smaller starter goal of $1,000 might be reached in a few months.
2. Pay yourself first, by automatic transfer. Choose an amount, even $50 a payday, and have it move to the reserve account on the day the paycheck arrives. Money you never see is money you never spend.
3. Redirect windfalls. A tax refund, a bonus, a gift or the proceeds of selling something you no longer use can fund a large share of the starter goal at once.
4. Pause the extras. While building the starter fund, make only minimum payments on debts, and put the extra here. Once the starter fund exists, the debt payoff plan can proceed, as described in Debt Snowball or Debt Avalanche? Two Payoff Plans Run on the Same Four Debts.
5. Then build toward the full target. Raise the transfer when income rises, and treat each month's contribution as a bill that must be paid.

For a household that finds the sums hard, the discipline of the envelope method can help, particularly the sinking-fund idea for predictable costs, which keeps small bills from raiding the reserve; see The Envelope Budget, Cash in Labeled Envelopes and a Month Worked to the Dollar.

Once the fund is in place, it needs rules. Spend it only on emergencies as defined above. After any use, refill it before resuming other goals. And resist the temptation to lend it, even to someone you love, because a reserve with a hole in it is not a reserve.

The strongest objection: idle cash loses to investing

The best argument against holding a large cash reserve is an economic one, and I will give it in full strength. Cash earns little. Inflation erodes it. Over long periods, a diversified portfolio of stocks has historically earned considerably more than a bank account. Therefore, the argument runs, every dollar sitting in an emergency fund is a dollar that could have been working, and a household that holds six months of expenses in cash is giving up a great deal of growth for no good reason.

There is truth in this, and I do not dispute the premise about returns. But the conclusion does not follow, and here is why.

First, the reserve is insurance, and insurance has a premium. Nobody argues that fire insurance on a house is a waste because the house has not burned down. The cost of the policy is the return forgone in exchange for protection against a loss you cannot afford. An emergency fund is the same trade. The "lost" return is the premium.

Second, the timing of emergencies is not independent of the timing of markets. Layoffs tend to cluster in downturns, and downturns are when stock portfolios are low. The household that invested its reserve may be forced to sell at exactly the moment prices are depressed. A hypothetical makes the point: suppose a household holds $25,000 in a stock fund as its "emergency money," the market falls 30 percent, and the household's job disappears in the same quarter. The $25,000 is now $17,500, and the household has locked in a loss of $7,500 to pay the rent. The reserve failed in the one circumstance it existed for.

Third, the reserve is what makes investing possible. A household with a cash cushion can ride out a downturn without selling anything, and that is the greatest advantage a long-term investor has. The cash does not compete with the portfolio. It protects it.

Fourth, the cost is smaller than the objection suggests. The reserve is a fixed amount, typically a modest share of a family's total assets over a lifetime. Every dollar beyond it can and should be invested. The question is not cash or investing. It is cash first, then investing, and the priority is what the argument is about.

The correct reply to "idle cash loses to investing" is that idle cash is not idle. It is working as a shock absorber, and a shock absorber that is also earning a return would be nicer to have than one that is not, but it is not a shock absorber you can do without.

What the founders said about prudence

The founding generation did not use the phrase "emergency fund," but they understood the principle. Benjamin Franklin's maxims, collected in 1758 in The Way to Wealth, return again and again to putting something by: a household that lays up a little in good times is not at the mercy of the bad ones. Benjamin Franklin's The Way to Wealth, Read Line by Line for Modern Savers reads the text closely for modern savers.

There is also a deeper link to independence. A family with a reserve can say no: to a bad job, to a predatory loan, to a relative who would like to lend on terms. The Founders' ideal of the independent citizen depended on economic independence, and a person who is always one bill from disaster is not fully free. Self-reliance is not only a matter of character. It is also a matter of cash.

The case in brief

1. An emergency fund is a cash reserve for unexpected, necessary and urgent costs, kept apart from savings for planned goals.
2. Without a reserve a shock becomes debt: a hypothetical $1,800 repair left on a 22 percent card costs about $396 a year in interest, while the same repair paid from savings costs $1,800 and ends.
3. The usual target is three to six months of essential expenses, and the range reflects your risk; for essentials of $4,200 a month that is $12,600 to $25,200.
4. Keep it in an insured, liquid, separate account; FDIC coverage is $250,000 per depositor, per insured bank, per ownership category.
5. Start with a small first goal and automatic transfers, and answer the investing objection with the insurance logic: the reserve protects the portfolio and the portfolio cannot replace it.

What you can do: this week, add up one month of essential expenses and open a separate insured savings account with an automatic transfer on payday.