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Financial Planning 101: Emergency Funds (Pay Yourself First)

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December 8, 2016
Emergency Fund: Responders on the Way
MattGush/Getty Images

An emergency fund isn’t just a repository of cash to dip into when the tires wear out or the dishwasher breaks down. Those emergency dollars can actually be critical to one’s overall investing strategy.

Let’s look at two different investors, one of whom has spent a few years building an emergency fund, with that money tucked away in a savings account and some short-term bonds. The other investor has the bulk of his money tied up in the stock market, which, as we know, can go down as well as up.

When a fierce autumn storm blows through town, both investors suffer major damage to their vehicles from falling branches. The bill for each, even after insurance, is around $1,000.

The first investor uses this as an occasion to dip into her emergency money, now literally a “rainy day” fund, to pay the repair bill. Her investments remain untouched, and can keep growing to meet her eventual goals, which may now include buying a new car without a damage history.

Because the second investor lacks an emergency fund, he faces the choice of selling some shares at a loss (it was a rough month for the market) or using his credit card to pay for the damage to his car. Neither choice is particularly palatable, because credit cards, while a short-term fix, can’t sustain the investor in the long term without potential financial damage. And of course, selling stocks at a loss could hurt the investor’s chances of reaching long-term financial goals.

“The last thing you want is to invest in the market and have to dip into your investment portfolio at a loss,” said Robert Siuty, Senior Financial Consultant, TD Ameritrade. “If your investment portfolio drops and you don’t have an emergency fund, you’ll panic, capitulate and sell at the worst possible time.”

The lesson? Keeping emergency funds grouped with long-term investments in the market can crimp your investment success.

Budgeting Can Be Key

Now that it’s clear why setting up a separate emergency fund can be critical from an investment standpoint, what are the dos and don’ts of getting started, how much is needed, and how can someone with debt and long-term expenses even find the money for an emergency in the first place?

It starts with budgeting. Figure out monthly expenses, every one of them, and determine which expenses can’t be avoided. An emergency fund generally covers the following types of outlays:

  • Food and shelter
  • Transportation
  • Insurance and health
  • Taxes
  • Cost of finding a new job

“Balance out committed expenses vs. stuff that’s more discretionary like going out for dinners and lunches and taking vacations,” Siuty said. “That’s stuff you can cut down on if you need to. When I sit down with a client, one of the first things I always ask is if they have an emergency fund. It’s what you want to tackle first.”

Where should emergency cash be stowed? It can be flat-out cash and savings that are easily accessed like CDs or money market funds, or it can be in shorter-term income investments at a brokerage. A savings account won’t earn much interest, but it’s one of the safer places to put money. On the other hand, a short-term bond fund, while somewhat less predictable and safe than savings, offers a better chance of making some compound interest on the original investment. Compound power can grow with time, because the money earned in interest begins earning interest as well.

Some investors set up a separate bank account specifically for emergency funds, while others keep emergency cash as part of their brokerage accounts, but sliced to the side, so to speak, so it doesn’t get mixed up with funds slated for longer-term goals like retirement.

One place to consider is a “robo” advisor like Essential Portfolios, an automated digital service that allows investors to easily input their personal goals, basic financial information, risk tolerance, and time horizon, and receive a recommendation for a diversified portfolio in 15 minutes. Advisory fees for an Essential Portfolio are 0.30%, and the minimum investment is $5,000.

How Much Do You Need?

So once an investor finds ways to save, how much should they devote to that emergency stash?

“The general rule of thumb is three-to-six months of expenses, but that’s not set in stone,” Siuty said. “It depends on personal lifestyle, career, and income. If income is a little more stable, maybe they can stick to something shorter. But if the situation is unstable or if they’re in a profession where maybe there’s risk of attrition, then they may want to have a longer type of fund set up.”

What about other important priorities, like paying off college debt, saving for a down payment on a house, and building education and retirement savings? Again, all that is important, but having emergency cash is the key short-term priority, because without it, longer-term goals could get dinged. And remember, there’s good debt and bad debt. Good debt is a mortgage because it helps build long-term wealth. Bad debt is credit card debt, which young investors should try to avoid by limiting expenses.

Siuty advises clients to put their goals into short-term, intermediate-term, and long-term buckets. The short-term budget is emergency savings. Intermediate can include buying a house and paying for college. Long-term is retirement. But the longer-term buckets might leak if someone fumbles on the short-term.

“You want to set up an emergency fund and have it in place sooner rather than later because things happen that can throw a wrench into your long-term plans,” Siuty warned.

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