We don’t have an emergency cash fund (yet). In our pursuit of early financial independence and early retirement, we have been aggressively investing all of our extra income. We want to make money work for us! Having an emergency cash fund seems to run counter to this strategy – after all, what’s worse than having cash lying around or in a traditional savings account, slowly losing value due to inflation?
An emergency fund is supposed to be an amount equal to a few months’ worth of living expenses that is liquid, easily accessible at a moment’s notice. It serves the purpose of covering unforeseen expenses or getting you through a period of reduced or no income so you don’t end up getting into debt in the process. Being liquid normally implies having the cash on hand, in a traditional savings account or a money market account, which means low interest rates. Therefore, having this fund will actually cost you money in two ways: first, the value of the cash decreases year on year due to inflation; second, there is an opportunity cost from not having the cash earn compounding interest in higher yield accounts or assets, like investing in dividend stocks.
For the past three years, our priority has been to build up a portfolio of investments that generate enough passive income, as well as continuously adding to our retirement accounts. Having an emergency cash fund was something we hadn’t really looked into. We figured that we didn’t really need to keep an emergency cash fund for the following reasons:
- When budgeting, we factor in a little extra to ensure enough cash flow for the coming months.
- If we need more than what we have available in our bank account, we have lines of credit that we can tap to help with immediate cash flow problems.
- We can always tap into our investment and retirement accounts if the amount needed exceeds our cash on hand and available credit.
For the most part, these are fairly reasonable arguments and have worked well most of the time. However, real life is hardly ever easy to plan and we’ve learned some tough lessons. Two incidents within the past twelve months have highlighted the issue with our current strategy, pressing us to rethink our approach to the emergency fund:
- In November 2013, when typhoon Haiyan struck the Philippines, my immediate family and many relatives were among those affected. With no certainty as to when food, water, and medical supplies would become available and with growing security concerns due to rampant looting, my family had to temporarily move to a different island. A lot of money was needed for transportation and for acquiring a rental place and basic necessities once they were relocated.
For us, the disaster not only caused emotional upheaval but was also a financial nightmare. We had just moved to a new apartment and had depleted most of our cash reserves from the cost of moving. We sent as much as we could to my family; my Japan bank account balance was uncomfortably close to zero. We were looking at liquidating some of our investments but ran into issues with making international wire transfers. Fortunately, with help from other relatives, we were able to pool enough money to meet the immediate needs.
- About a month ago, my mother found out from concerned neighbors that an empty lot that we own adjacent to our family home was being used for drug sessions by unsavory characters at night. We had planned to fence off the area but never got around to it. Now, it seemed imperative to get the fence up, since we didn’t know what kind of illegal activities were being conducted by strangers in our neighborhood.
The estimate for building a concrete fence around the area was $5000. I was shocked at how expensive it was. When I checked our budget for the year, I knew we would be getting into cash flow problems, given that our baby and several tax payments are due in just over a month. I have ended up borrowing the money to cover this expense for the meantime.
We’ve realized now the issues with our initial assumptions:
- The extra money in our budget that we factored for emergency expenses was good enough for small items, for example, getting a broken appliance fixed or replaced, paying a higher than normal utilities bill, or even extra medication and covering a doctor visit if someone got sick. The amount was insufficient for any major emergency, such as natural disasters like Typhoon Haiyan or someone in the family requiring serious medical treatment.
- Credit can help manage cash flow issues but is a step towards getting into debt. It’s also not always an alternative. For many places around the world, cash is still king. I am unable to use my credit card for many transactions here in Japan and the same is true in the Philippines. Cash advance from your credit card may be an option but will drown you in fees and exorbitant interest rates.
- Tapping your investments and retirement accounts come at a cost, which may be very high depending on your timing. For example, our stock portfolio has mostly long-term positions and if we were forced to sell securities to get cash during a market dip, then we would end up with losses. And it’s usually during market crashes, when the economy is suffering, that people will find themselves in need of money.
Withdrawing from your retirement account may also cost you. Your accounts may have penalties for early withdrawal and you may end up with additional tax liabilities.
Also, one thing to think about is how fast you will be able to liquidate assets during an emergency. What if you need the money during the weekend or on a holiday, when the markets are closed?
Something else that we had not factored in: financial transactions abroad are a huge pain. Yes, online banking is ubiquitous and theoretically you should be able to transfer money anywhere, anytime. Our experience has taught us otherwise. We’ve put in wire transfers from one US bank to another US bank that have not gone through, with neither bank being able to explain the error in the transaction that we only learn about several days later. Some banks still require you to appear in person to put in an international wire transfer or to register a foreign recipient account in person before being able to use them in online or phone wire transfer services. Since we have accounts in different parts of the world, accessing the money we have has not been easy.
Finally, there is one important thing that an emergency cash fund can provide – peace of mind. When an emergency strikes, everyone is already highly stressed. Add financial worries to the mix and you end up with an extremely volatile and emotional situation.
I’ve been convinced. We do need to have an emergency cash fund as part of our overall financial independence strategy and we need to start building it now!
I was looking for expert advice to decide how much cash is enough. The answers have varied widely – I’ve seen suggestions from 3 months to 12 months worth of living expenses! To get up to 3 months or more is going to be a significant savings effort. For me, 3 months worth of living expenses is a reasonable amount of cash to have on hand for emergencies and is something that can be set as an initial goal.
How long will it take to build up the emergency cash fund? Assuming that anything leftover from our income after our monthly living expense goes to the cash fund, then this simplified formula captures the number of months required to build the fund:
M = m x ((1 – r) / r)
M is the number of months I will need to keep saving up for my emergency cash fund
m is the number of months of living expenses I need in my emergency cash fund
r is the percentage of my monthly income that goes to the emergency cash fund
For example, if I wanted to save up 3 months worth of living expenses (m=3) and 5% of my monthly income goes to my emergency cash fund (r=0.05), then it would take me
M = 3 x ((1-0.05)/0.05) = 3 x (0.95/0.05) = 3 x 19 = 57 months
Again, this is a simplified formula that assumes monthly income goes to just living expenses and the rest of it will go to the emergency cash fund. I obviously don’t want to spend the next five years just building a cash fund and our savings rates are much higher. Using a 20% rate of savings for the cash fund, we should be able to reach our goal in one year.
Hope for the best and plan for the worst – this is effectively our motivation for getting our emergency cash fund in place. We cannot shield ourselves from disaster but we hope to weather the next one with at least some emotional security from knowing the cash will be on hand when we need it.