Conventional Wisdom: The Emergency Fund

This is the second in a series inspired by a simple toy at CNNMoney that probably doesn’t deserve the attention. (See the first post in the series here.)

Question three in the financial health quiz is "How many months of expenses do you have in an emergency savings account?" The right answer is pretty simple:

You should keep three months’ worth of living expenses in a bank savings account or a high-yield money market fund for emergencies. If you have kids or rely on one income, make it six months.

In other words, you should have six months expenses in cash unless you are a two income household with no kids, a.k.a. DINKs.

Now I happen to think that six months is generally too much, but what makes this sort of conventional wisdom truly infuriating is its one-size-fits all nature. I am sure its defenders will say it’s just meant as a guideline or rule of thumb, but that just begs the question of why we need such a dumbed-down guideline to begin with. Can’t some things in our lives be just a little complicated?

Before going further, let me define the often undefined term of "emergency fund." This is money you have designated for use in an actual break-glass-in-case-of emergency. Events that, knock on wood, may never happen. For example, you become unemployed or your brother needs to be bailed out of jail. The random largish expenses that befall us all, the exploding water heaters and pricey dental work, are not emergency fund items. That sort of stuff will definitely happen to you. Budget for it.

It seems to me that as a first cut there are three categories that a person or household could fall into that would define the parameters of the emergency fund question. The first group are folks like me, who do not need an emergency fund at all.

Yikes! Frank, isn’t that irresponsible? Don’t you have kids?

I have kids, but I also have liquid assets. I’ve got a brokerage account with stocks and bonds worth several years of expenses. None of it is in cash, e.g. a money market fund, but I can sell something to raise money with a few mouse clicks. My broker has even thoughtfully provided me with a checkbook so I can spend money in an emergency right away.

I may be exceptional in the ratio of liquid assets to expenses (anti-social bloggers don’t spend that much) but I can’t be the only guy in America with a brokerage or mutual fund account that could be turned into ready cash at short notice. And yet I can’t remember ever seeing a personal finance writer mentioning, even in passing, that this emergency fund thing may not apply to some folks.

Of course, the key issue is one of liquidity. The second division a person could fall into in my scheme of three groups is people who are possibly just as well off as the ones in the first group, but don’t have assets they can tap so easily. In particular, I’m thinking of people who have equity in their homes and retirement accounts like 401(k)s and IRAs.

There is a whole personal financial advice sub-genre (e.g. The Automatic Millionaire) devoted to urging people to put their savings into these not-so-liquid places exactly because it is hard to get money out. Under this philosophy what most rational people would see as an advantage, the ability to access your savings when needed, is a disadvantage. Hence the need for a separate pot of cash you can draw on.

But a person in this group has relatively easy to describe requirements for an emergency fund. It would need to be large enough to a) provide a buffer to keep from expensively tapping the illiquid assets for a smallish emergency and b) tide the person over until they can liquefy some of their assets in a big emergency. Of course, circumstances will vary from person to person, but it seems to me that a month or two of expenses would be adequate here.

It is also worth considering that for these illiquid asset owners the option to borrow as needed against assets can replace the need for an emergency fund. Many 401(k) plans allow participants to borrow from them at short notice without negative tax effects and if a person has significant equity in a house a standby HELOC might be a good choice.

The third category of people is the one that, I think, most financial advisors have in mind when they talk about emergency funds. These are the millions of people with low or negative net worth, i.e. debtors. And for them the decision on how large to make the emergency fund is much harder.

The stakes are raised because, for a person who owes money, maintaining an emergency fund can be very expensive. If you are carrying credit card debt at 20% interest, then every dollar in your emergency fund is costing you 20 cents a year. (Okay, a little less because you get some interest on that dollar, but you get my point.)

Six months of expenses in the bank sounds like a reassuring and prudent thing, but you have to ask how likely it is that that sixth month’s worth of money will be used. If the answer is that it’s pretty darn unlikely, then what you have is an over-priced insurance policy, with a premium equal to the interest on the debt you could have paid off with the money.

Of course, the obvious source of emergency cash for a debtor is more debt. That doesn’t sound very appealing, but we are talking about true emergencies, not another ill-advised trip to the mall. Unless you are a fundamentalist no-debt-ever type, you ought to concede that borrowing in an actual emergency makes sense.

But there is a potential problem with that which got some people excited earlier this year. It is possible that in a crisis, just when you need to borrow most, you won’t be able to. You lose your job and the card companies cancel your credit. This is the fear that caused Suze Orman to lose her mind in the spring. (See also my related business idea.)

I acknowledge that this is a bad year to be dismissive the worst case scenario, but you have to draw the line somewhere. To use one of those strained analogies I am so fond of, an emergency fund is like a lifeboat. How big and elaborate a lifeboat you need depends on your circumstances: how far from shore you are sailing, the climate you are sailing in, how many people might need to use it, and so on. But bigger is not always better. You have to pay for the lifeboat and carry it on the deck of your main boat.

Not only is the one-size-fits-all answer to the emergency fund question needlessly general, it’s not even appropriate for most people. Some households, the ones sailing far from shore in the icy North Atlantic, should have six months expenses salted away. But that turns out to be a fairly extreme case. It is as if the one size for everybody was XXL rather than medium. One, two, or three months makes more sense for most people, and yes, zero is often the right answer too.

Credit Cards, Investing, Media | Frank Curmudgeon | October 20, 2009 12:30 pm

234 Comments

By Larry, October 20, 2009 @ 12:56 pm

Orman on her Saturday night show is now shrieking like an out-of-control harpy that everyone needs eight months of expenses in an “emergency account,” which as far as I can tell amounts solely to FDIC-insured cash. Not seven and a half months, mind you, that’s not good enough, but at least eight. I don’t know out of what hat she plucked this one-size-fits-all number, but my guess is that it’s the average time needed to find a new job if one is terminated or laid off. But even this formula neglects other sources of income the unemployed might tap into, such as unemployment insurance and severance pay, as well as other possible expenses such as job-hunting costs and paying COBRA. And then there is the obvious fact that for some people eight months is more than ample time to find a job while for others it’s not even close. And she uses this eight-month figure to routinely “deny” even otherwise financially stable people the right to make purchases that might enrich their lives, and completely ignores the fact that cutting back spending in a recession is the ideal way to ensure that businesses won’t stay alive because people are afraid to buy.

I have only about 2 1/2 months of expenses in FDIC-insured cash and only about $500 on my credit card, and while my stocks and bonds are all in my retirement accounts, at age 61 I could tap into my Roth (which will give me about 4-5 more months of expenses) tax-free, and I have other sources of funds besides. It’s good to know someone is questioning the wisdom of the emergency fund.
By The Incidental Economist, October 20, 2009 @ 2:04 pm

I agree with you. And there is some literature (studies) that support our perspective that an EF isn’t necessarily right for everyone. I’ve got a post coming out that summarizes that literature. Unfortunately due to an immense backlog of good material my post isn’t due out until December.

(“Frank,” if you can’t wait that long and are interested in the literature citations you can contact me.)
By Neil, October 20, 2009 @ 2:06 pm

Completely agreed. I wrote an article not long ago about the pitfalls of emergency funds within the third group. My conclusion was that anyone with high interest, revolving debt is wasting their money if they’ve got one.

Somebody with the financial wherewithal to save 3-6 months of expenses is not likely to be someone who will have credit denied to them if they need it. They’re the “low net-worth but good credit risk” group. Why would someone turn them down? I could lose my job…my credit card company and the bank where I have an untapped, unsecured line of credit (worth about 6 months expenses, as it happens), would not know about it, so I’d be able to borrow as needed when such an emergency happened.
By Adam, October 20, 2009 @ 2:15 pm

For past generations, when you needed to repair your car, visit the doctor, or put food on the table when you were out of work, you “dippped into your savings.” I think it’s a sign of how far we’ve gone from this that a cash savings account needs to be rebranded, promoted and hyped as an “emergency fund” for people to put a few dollars away.
By Mike Piper, October 20, 2009 @ 2:44 pm

I think the disagreement here may have something to do with terminology.

You say, “The random largish expenses that befall us all, the exploding water heaters and pricey dental work, are not emergency fund items. That sort of stuff will definitely happen to you. Budget for it.”

To me (and many other personal finance writers, I suspect), those are exactly the things an emergency fund is for–as well as the things you describe as an emergency.

So when you ask “how likely it is that that sixth month’s worth of money will be used?” the answer for those using the “emergency” definition I use is closer to “pretty darned likely.”
By SJ, October 20, 2009 @ 3:16 pm

Wow. your metaphors are always entertaining and great.

Life boats hahaha… And if you are on the titanic, might as well bring none cuz you’re screwed either way; present american though perhaps?
By Rick Francis, October 20, 2009 @ 4:12 pm

Frank,

I also have been using a brokerage account as one level of my emergency fund… You’re right few writers even mention that possibility. I suspect because there are a lot less people with brokerages accounts than savings accounts and there is the risk of being forced to sell at the bottom of a bear market, like Mar 2009!
My solution is to keep a much smaller liquid account that I can tap first. My reasoning is that even a really big emergency is unlikely to require a huge immediate payment, but “largish” immediate payouts aren’t too uncommon- like the water heater example.

-Rick Francis
By Adam, October 21, 2009 @ 9:41 am

The one size fits all advice is a bit irritating, isn’t it? Especially Suze (who I actually like as an entertainer) and her 8 months totally liquid EF. The other part of that is that while 3 months might be an obtainable and worthy goal for some of her followers, 8 months becomes such a large amount of money that people would become disillusioned and not even try.

For me, 2 months of expenses is plenty to keep in a “high interest savings account” (whopping 2% right now!).

Everything else goes into my web broker account and my retirement accounts (Roth and 401(k)).
By Rob Bennett, October 21, 2009 @ 2:01 pm

Rules of thumb cause great financial damage to the people who take the stuff put forward by the money “experts” of today more seriously than it deserves to be taken.

There is a place for them. But responsible “experts” would explain the caveats. Those focused on marketing report the rules of thumb as if they represented Divine Truth.

We live in a Marketing Age. It is bankrupting us. Marketing should be placed second to accuracy. Even by “experts.”

Rob
By Frank Curmudgeon, October 22, 2009 @ 3:08 pm

Mike: The terminology is a little squishy, which is why I defined what I am talking about fairly high up in the post. Measuring in terms of months of expenses and worrying about the economy says to me that what most people are talking about is disaster (unemployment) preparedness. Not having enough cash to pay for a water heater, and having to borrow at a high rate to do so, is also a bad thing but it’s more of a living beyond your means now thing than a disaster insurance thing.
By Financial Samurai, October 25, 2009 @ 12:57 am

3 months of EF too much? No way. Perhaps after 36 months is it too much.
By Naomi, November 5, 2009 @ 12:40 pm

“I have kids, but I also have liquid assets. I’ve got a brokerage account with stocks and bonds worth several years of expenses. None of it is in cash, e.g. a money market fund, but I can sell something to raise money with a few mouse clicks.”

I would argue that you’re not liquid. Liquidity is not the ability to convert assets to cash quickly. Rather, it is the ability to convert assets to cash quickly with a minimum loss of value. Stocks and bonds don’t fit that definition.
By Investing 101, November 16, 2009 @ 12:19 pm

I agree with Naomi. Liquidity is not the ability to convert assets to cash quickly. Besides, depending on the circumstances, some assets you thought were highly liquid can sour very quickly and you’re left holding the bag, so to speak.

I tend to agree that 3 to 6 months of living expenses is good enough for an emergency fund. And like Frank said, you have to pay for the lifeboat. In the case of the emergency fund, you pay in the form of loss to inflation and opportunity cost if you had put that same money to work in higher yield investment vehicles.
By Wodenodin, March 9, 2010 @ 4:46 am

I’d like to offer an example of why the ‘one size fits all’ equation certainly doesn’t work for many. The government is a major employer in this country and I’d hazard a guess that many government employees have at least similar circumstances to ours. We’re DINKs and both work for the government. We both contribute to 457 retirement plans, whereby you can withdraw the money, penalty-free, retiring at any age. (There are also other separate 403B pension accounts where penalties would apply.) In other words, we *could* easily tap those 457 plan funds if laid off, penalty-free. We’re also able to ‘bank’ our leave time, which would be ‘cashed out’ were we to be laid off. Many of our peers have 500 hours of vacation plus 80 hours PPL in the bank. The leave time in and of itself is well over three months’ expenses. You can also bank thousands of hours of sick leave, should illness become the ‘emergency’. We choose to buy some short-term disability insurance and are covered for long-term disability through our retirement plan. We’re close to the point where we *could* live off of one income if we lower our standards a little. My calculation for the appropriate size of an emergency fund involves multiplying the anticipated shortfall should we be down to one income by three months. Presumably there would be unemployment checks were one of us to be laid off, which aren’t even factored into that equation. It puzzles me that mainstream financial advice and financial calculators, etc. seem to completely overlook government workers (who are a fairly large percentage of the population) when making these broad recommendations.
By FatMickHead, May 26, 2011 @ 5:07 pm

Actually, the ability to convert to cash quick IS the definition of liquidity. Stocks are liquid, real estate less so, and family partnerships are really illiquid. What stocks are is volatile. There is a difference.
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