The emergency fund is often hailed as a mandatory component of a sound personal finance plan. And whilst I agree that an emergency fund is necessary, I did recently cut my emergency fund in half. Allow me to explain why this may be a good idea in certain cases.
Normally, people are advised to build an easily accessible emergency fund that covers six months of living expenses. The emergency fund is there to help you pay for large unexpected drains on your finance. Think of sudden medical costs, vehicle damage, home damage or a costly mistake in your tax return three years ago.
I’m a big fan of the emergency fund and I have one. What I am however not a fan of, is having too much money sitting idle and the possible opportunity costs associated with this. And for my particular situation, I think the standard 6 month emergency fund is too much.
How much emergency fund do you need?
To determine how much emergency fund you really need, you need to sit down and think of the potential risks you may be facing. In my unscientific opinion, the bare minimum for an emergency fund is three months worth of expenses. To see if you need more, ask yourself the following questions:
- Do I have children?
- Do I have a ‘high maintenance’ pet?
- Do I have a home?
- Do I have a car?
- Do I have a medical condition?
- Do I have insufficient health insurance?
For every ‘yes’ you answer to the above questions, you should in my opinion add one month worth of living expenses to your emergency fund, on top of the three month baseline.
In my case, it’s quite simple. I’m a 30-something with no kids an no pets. I don’t own real estate, I don’t have a car, I’m perfectly healthy, I have private heath insurance and through my super fund I’m even insured for disability. The main reason why I would need an emergency fund, is to help me through periods of unexpected unemployment.
Why I’m comfortable with only 3 months
First of all, I work in a ‘hot’ industry that is rapidly growing, so I don’t think employment will be an issue in the short to medium term. But if the digital economy were to suddenly go tits up, I’d have three months worth of expenses stashed away in my emergency fund.
Why is three months enough? Allow me to introduce you to two wonderful concepts: notice period and redundancy pay (also called severance pay). Here in Australia, companies are legally required to give an employee a minimum notice period when they are made redundant. On top of that, they also have to pay that employee a certain amount of money to help cover living expenses.
The amount of notice and redundancy pay you can expect is mainly dependent on how long you’ve served with the company. In my case, I already have a five year tenure under my belt. So even if I were to be made redundant, I would still have 14 weeks = 3.5 months of salary coming my way. If the company were to go bankrupt, the government will foot the bill.
In short: I really only need a 3 month emergency fund.
The opportunity cost of hoarding cash
Besides that the fact that I simply don’t need 6 months worth of cash idling in my bank account, the truth is that I would in fact be hurting myself in the long term if I were to do this.
Let’s run the numbers. My monthly expenses total about AU$3,000. My emergency fund was $18,000 but will be brought down to $9,000. If we plug a $9,000 investment witha market average return of 7% in the ASIC Moneysmart compound interest calculator, this happens:
Yes you are seeing that right. In 10 years, that 7% average return would double my money (remember the rule of 70?). So not investing this money and having it sit in a savings account means I’d be leaving $9,000 on the table. That’s 0.9% of a million bucks…
TLDR: thanks to several entitlements I’ve built up over the years, it turns out I didn’t need a 6 month emergency fund. By slashing it in half and investing the difference, I may have saved myself a good $9,000 over 10 years.