Key Post How much of an emergency fund do I need?

[Brendan Burgess]

This comes up from time to time, and there is a custom and practice answer that everyone should have 6 months' expenditure in cash in case of some unforeseen expenditure. This is too simple an answer and it results in most people having way too much cash wasting away in a low interest deposit account.

If you fall into the following categories, you need a bigger emergency fund

• Self-employed - your income is uncertain - business might decline or debtors might be slow in paying
• Uncertain employment outlook - if you might lose your job suddenly, you will need a fund to pay the mortgage
• Sole breadwinner for a large family
• Living on the breadline anyway - any fall in income will cause you real hardship
• An old unreliable car, washing machine, fridge etc that could go at any time
• Health problems - you may face health costs
• Landlord - your income is uncertain as your tenant may stop paying
• Cheap tracker on an investment property - you absolutely must have cash to make sure that you can keep up the full repayments so you don't risk losing the tracker
• A bad credit record, so no access to borrowing
• A low credit card limit

If you plan to replace your car, you should have a fund to do so

• If you know that you will need €10,000 next year to replace your car, then you should be building up a fund to do so to avoid expensive borrowing. It would make no sense to pay a lump sum off your mortgage which would save you 4% if you know that you will be borrowing at 12%.

However, the following categories need smaller funds, and may not need a fund at all

• Secure, well paid PAYE employment
• Both spouses working, so even if one loses their job, there will still be an income
• Income well in excess of your expenditure
• Newish car, fridge, washing machine etc.
• A high, unused, credit card limit or overdraft facility
• A good relationship with your bank or credit union which will give you a loan if you need it
• Family who will help out in an emergency if needed
• Liquid assets such as shares which can be sold quickly if necessary

Credit union and credit card borrowing and emergency funds

I am appalled at the number of people who have rainy day funds while having expensive borrowing. So they are paying 12% on their credit union loan or 20% on their credit card while having a lump of money on deposit paying 1%.

The worst example of this is people who have €10,000 in the credit union but leave it there and borrow another €10,000 because they don't want to touch their savings. This is probably costing them €900 a year. And the deposit provides no security, because the Credit Union probably won't let them have it as it's security for their loan.

If you are paying interest on your credit card, you should use your rainy day fund to pay it off. If you face some emergency, at worst, you can borrow on your credit card again.

Mortgages and emergency funds
There could be a case for having an emergency fund while having a mortgage.

If you have a cheap tracker, then it's not costing you anything to have an emergency fund.

On the other hand, if you have an expensive variable rate mortgage, it might be worth paying down the mortgage especially if it allows you to avail of a lower LTV band.

If you do pay down your mortgage, tell your lender that it is a payment in advance, so you can stop making regular monthly repayments if you face an emergency.

What to do with a redundancy lump sum
This can be a very complex decision. If your job outlook is uncertain, you want money to supplement your social welfare. However, if you have high short term borrowings such as a credit union loan or a credit card, you should pay these off.

If you are coming to the end of Jobseekers Benefit, having a lump of cash might affect your means tested Jobseekers Allowance, so you should probably pay down your mortgage.

 

[Brendan Burgess]

Your emergency fund does not have to be in a bank account

If you have a portfolio of liquid shares, you can turn part of them into cash in a few days.

Sarenco said in response to this point in another thread:

Sure, they could liquidate their share portfolio but share prices would inevitably plummet in a financial crises - US stocks lost 90% of their value in the two years following the 1929 crash and over 50% of their value in the recent 2008/2009 crash. Having to liquidate a share portfolio at the worst possible time would permanently lock in these types of losses.

Sarenco's advice was that the couple with an income of €6,500 a month and a mortgage costing 4% should have an "absolute minimum" of 6 months' expenditure. So this would probably be around €36,000.

So, in effect, he is advising them to borrow €36,000 @4% to put it on deposit at 1%, in case there is a stock market crash. So they are paying a premium of €1,000 a year for this insurance.

This makes no sense to me. For there to be any pay off to this strategy, the couple would have to lose their secure jobs just as the financial crisis hit. Most people actually kept their jobs during the financial crisis.

And while stocks have a habit of severe and sudden falls, it's usually after a period of sustained growth in prices.

If you are building up an education fund for your children, you won't need a emergency fund

A lot of people have fund for their kids' education and will be reluctant to touch it.

But again it makes no sense to have a kids' fund and an emergency fund and a mortgage at the same time. It's this type of thinking which makes the banks so profitable.

If you have an education fund, you can access it in an emergency and replenish it later.

 

[Brendan Burgess]

Other ways of coping with emergency cash demands

1) Most people have access to credit
Make sure you have a small credit union account, so that if you do need to borrow, they are more likely to lend to you.
Make sure you have a decent limit on your credit card. Credit card borrowing is expensive, but if it's an emergency, spend it and try to clear it before interest becomes due.
Don't be afraid to ask family or friends for help. It is an emergency.

2) If you lose your job, you will probably get a redundancy payment.
People seem to forget this. It will often be enough to tide people over for a few months.

3) Cut down discretionary expenditure
If you are overpaying your mortgage, stop it.
If you are making AVCs, stop them.

4) Check if your mortgage lender will allow you take a break without impacting your credit record
If you are a ptsb customers, any overpayments you have made go into a credit account - the opposite of arrears. You can stop paying your mortgage and "use up" the credit.
Some other lenders allow you to take two payments breaks of up to 6 months over the life of the mortgage.

5) And if you really need it, you can reschedule your mortgage
This should be avoided if at all possible as it will impact your credit record.
But in a real emergency, if you have used up all other sources, talk to your lender and you may get a reduced payment or a full moratorium on payments.

 

[Sarenco]

Brendan

A few thoughts:-

• I certainly agree that it makes no financial sense to maintain a significant cash reserve while carrying expensive, unsecured debt. However, I would argue that carrying such debt is itself an emergency from a financial perspective.

• Budgeting for anticipated future expenses (replacing a car, house repairs and maintenance, education costs, etc.) should be separated from any decision to maintain an emergency fund. These costs can be anticipated and therefore, by definition, are not emergencies.

• A six-month emergency fund of €36,000 implies average household expenditure of €6,000 per month - that seems like a very high level of expenditure to me. That equates to expenditure of €72,000 per annum out of after-tax income.

• I would view an emergency fund as effectively a form of self-insurance against a sudden drop in income and/or an unanticipated spike in expenses. Like all forms of insurance, this comes at a cost (in this case the opportunity cost of not paying down a mortgage or investing the sum elsewhere). Given the risks involved, the relatively modest "cost" of maintaining an emergency fund seems entirely appropriate to me. I acknowledge, however, that the current spread between deposit and mortgage rates, coupled with punitive DIRT rates, means that the cost of maintaining an emergency fund is artificially high at the moment for many mortgagors.

• An emergency fund equivalent to six months of average household expenditure is not particularly conservative - many people would recommend maintaining double that amount as an accessible cash reserve before investing in higher risk assets.

• During a financial crisis, a secure job may turn out to be anything but secure. Credit is typically not advanced, at anything like reasonable rates, to somebody with no income. It seems to me that good financial planning is as much about protecting your down-side as it is about about maximising potential returns.

• Ultimately, maintaing an emergency fund is about managing risk. While it is certainly true that many people retained their jobs during the most recent financial crisis, many others were not so fortunate. It is also the case that most people that managed to retain employment did so at considerably reduced rates of remuneration, particularly on an after-tax basis.

• Equities have historically always proven to be the best performing asset class over very long time periods (30 years plus). However, the volatility of equities over shorter time periods make them unsuitable for an emergency fund. For example, the total annual return (with dividends reinvested) of the FTSE100 over the 15 years to the end of 2014 was 2.89%. A simple cash deposit would have comfortably beaten that return over the same time period. More importantly, there were two drawdowns of 40% plus during that period - if you had to liquidate stock positions during those periods to simply pay the bills, your losses would be permanent.

• While it is certainly true that there is very often a run up in stock prices before a crash, there is no way to know, in advance, whether you are buying at or near the top of the market. It is the volatile nature of the stock market that makes it an unsuitable home for funds that are intended to meet short or medium term liabilities.

 

[Brendan Burgess]

Budgeting for anticipated future expenses (replacing a car, house repairs and maintenance, education costs, etc.) should be separated from any decision to maintain an emergency fund. These costs can be anticipated and therefore, by definition, are not emergencies.

A lot of people have an emergency fund in case they need to replace their car or their washing machine goes bust. So saving for one should not be separated from the emergency fund. Money is interchangeable. There is no difference between a euro you have earmarked for a car and one you have earmarked for an emergency. One of the most common financial mistakes is that people do actually compartmentalise their money. "That is my education fund" and "that is my long term savings fund". They should all be planned together.

A six-month emergency fund of €36,000 implies average household expenditure of €6,000 per month - that seems like a very high level of expenditure to me. That equates to expenditure of €72,000 per annum out of after-tax income.

The poster who gave rise to this discussion had a net income of €6,500 per month. You suggest that people need "at least 6 months' expenditure". Maybe they could cut their expenditure in an emergency?

An emergency fund equivalent to six months of average household expenditure is not particularly conservative - many people would recommend maintaining double that amount as an accessible cash reserve before investing in higher risk assets.

I am challenging the lazy conventional wisdom here. Most people plan their finances very badly.

Ultimately, maintaing an emergency fund is about managing risk. While it is certainly true that many people retained their jobs during the most recent financial crisis, many others were not so fortunate. It is also the case that most people that managed to retain employment did so at considerably reduced rates of remuneration, particularly on an after-tax basis.

But having a salary reduction is not an emergency! If one's salary is reduced, one has to cut one's expenditure accordingly. I would guess that most people who did lose their job got a redundancy lump-sum.

While it is certainly true that there is very often a run up in stock prices before a crash, there is no way to know, in advance, whether you are buying at or near the top of the market. It is the volatile nature of the stock market that makes it an unsuitable home for funds that are intended to meet short or medium term liabilities.

I can't see how the volatility has anything whatsoever to do with it. I think you are confusing many different issues here. Say I have a portfolio of €100k worth of shares. I don't know if I am buying at the bottom or the top of the market. If I am at the bottom well the share price will increase before the fall. If I am at the top, chances are that I paid €50k for the shares over the last few years.

And, of course, I do not need to cash out my entire portfolio. If it were a property, I would have to sell it all or not sell it. But with shares, one can sell part of the portfolio.

 

[trasneoir]

There is no difference between a euro you have earmarked for a car and one you have earmarked for an emergency.

Granted, but if I spend that euro on a car today, I can't spend it on an emergency tomorrow.

One of the most common financial mistakes is that people do actually compartmentalise their money. "That is my education fund" and "that is my long term savings fund". They should all be planned together.

As a disciple of the "zero based budget", this raises my hackles a little. If your point is that there doesn't need to be a 1:1 relationship between a euro's "purpose" and it's "location", then I'm with you.
For example: say I have a 15k emergency fund, and 15k in other sinking funds for semi-predictable expenses (replacement car, replacement boiler, christmas). I don't need to have the whole 30k languishing in an instant-access "emergency" account at 1%, because I'm never going to need all of it at once. I'll keep 20k liquid, and if I spend 10k on a car I'll top it up before I invest anywhere else.

 

[Sarenco]

A lot of people have an emergency fund in case they need to replace their car or their washing machine goes bust. So saving for one should not be separated from the emergency fund. Money is interchangeable. There is no difference between a euro you have earmarked for a car and one you have earmarked for an emergency. One of the most common financial mistakes is that people do actually compartmentalise their money. "That is my education fund" and "that is my long term savings fund". They should all be planned together.

I would have thought that setting money aside for an anticipated future cost (such as replacing a car) is simply budgeting, which is obviously quite different to setting aside a cash reserve to meet unanticipated future costs or an unanticipated drop in income. I'm not sure I really understand your objection to people compartmentalising their money for different purposes (although I certainly agree that it doesn't make sense to maintain a significant cash reserve for one purpose while simultaneously carrying expensive, unsecured debt).

The poster who gave rise to this discussion had a net income of €6,500 per month. You suggest that people need "at least 6 months' expenditure". Maybe they could cut their expenditure in an emergency?

Yes, I do think that people should establish a cash reserve equivalent to at least 6 months' average household expenditure whenever possible. However, I'm not sure why you would assume that a household with a monthly net disposable income of €6,500 would have monthly expenditure of €6,000 - that seems like a very high level of expenditure to me.

I am challenging the lazy conventional wisdom here. Most people plan their finances very badly.

Fair enough but I suppose one man's lazy convention is another man's time tested wisdom!

But having a salary reduction is not an emergency! If one's salary is reduced, one has to cut one's expenditure accordingly.

Well, a significant drop in income is certainly an emergency if it means you can no longer pay your bills! Significantly cutting expenses may not be feasible or sufficient in every circumstance.

I can't see how the volatility has anything whatsoever to do with it. I think you are confusing many different issues here. Say I have a portfolio of €100k worth of shares. I don't know if I am buying at the bottom or the top of the market. If I am at the bottom well the share price will increase before the fall. If I am at the top, chances are that I paid €50k for the shares over the last few years.

And, of course, I do not need to cash out my entire portfolio. If it were a property, I would have to sell it all or not sell it. But with shares, one can sell part of the portfolio.

Well, setting side a reserve to meet emergencies is far less useful if there is a possibility that the assets constituting that reserve could fall dramatically in value at the very time you need to liquidate the assets. This is precisely why the reserves maintained by insurers are primarily held in highly-liquid, short dated debt securities and money market instruments.

To be fair you have always been very transparent regarding your enthusiasm for investing in equities. That's obviously fine but I think it is fair to say that the conventional view is that equities are an inappropriate asset class for meeting short term liabilities.

 

[Brendan Burgess]

Let me deal with the compartmentalising issue.

Let's say I have an emergency fund of €20k.
And I now need to replace my car which will cost €20k.

I should spend the €20k on the car instead of borrowing the €20k.

I will now be able to save the repayments and rebuild my emergency fund over time.


Let's say I decide I need an emergency fund of €20k.
Let's say that I am planning to buy a car in a year's time for €20k.

Most people will compartmentalise and build up two cash funds of €40k which is way too much cash to have.

So the additional €20k should be used to overpay the mortgage or to invest. And then after buying the car, build up another emergency fund.

 

[Brendan Burgess]

Yes, I do think that people should establish a cash reserve equivalent to at least 6 months' average household expenditure whenever possible. However, I'm not sure why you would assume that a household with a monthly net disposable income of €6,500 would have monthly expenditure of €6,000 - that seems like a very high level of expenditure to me.

I am not sure what you mean here.
Should someone establish a reserve equal to 6 months' of their average monthly expenditure or should they establish a reserve equal to 6 months of the expenditure for an average household?

I would guess that most people earning €6,500 who have a mortgage are spending around €6,000. I think it would be crazy for the OP to have a reserve of €36,000 which could be used to pay down his mortgage which is probably costing him 4%.

If you reckon that the average household has an expenditure of €2,000 and you think he should have €12,000, I would still disagree with you but not as much.

 

[Brendan Burgess]

Well, setting side a reserve to meet emergencies is far less useful if there is a possibility that the assets constituting that reserve could fall dramatically in value at the very time you need to liquidate the assets. This is precisely why the reserves maintained by insurers are primarily held in highly-liquid, short dated debt securities and money market instruments.

To be fair you have always been very transparent regarding your enthusiasm for investing in equities. That's obviously fine but I think it is fair to say that the conventional view is that equities are an inappropriate asset class for meeting short term liabilities.

Comparing the reserves of an insurance company is totally inappropriate. An insurance company has a predictable outflow of cash.

We are not talking about short term liabilities here. I have always said that equities are not appropriate if you are planning to spend the money in the short term. We are talking about a potential liability that is unlikely to arise. It might happen. It might actually happen at a time when the stockmarkets have just fallen. It may even happen after just after the stockmarkets have just fallen, just after a previous fall. You need to balance the definite savings in mortgage interest vs. the potential need for an emergency fund.

 

[Sarenco]

Should someone establish a reserve equal to 6 months' of their average monthly expenditure or should they establish a reserve equal to 6 months of the expenditure for an average household?

The former.

I would guess that most people earning €6,500 who have a mortgage are spending around €6,000. I think it would be crazy for the OP to have a reserve of €36,000 which could be used to pay down his mortgage which is probably costing him 4%.

If you reckon that the average household has an expenditure of €2,000 and you think he should have €12,000, I would still disagree with you but not as much.

Well, I think it would be crazy for any household to spend €6,000 per month, in the absence of exceptional circumstances, regardless of their income - but there you go.

 

[Steven Barrett]

Yes, people compartmentalise their money all the time, it makes it easier to understand...that is for emergency, that is for education, that is for pension etc.

But cash should form part of an overall portfolio in that it is liquid and reduces the overall risk of your portfolio. Do you think having a 100% equity portfolio is a prudent strategy? Having to sell in an bear market will only result in you running out of money quicker.


When deciding on the level of emergency fund required, I agree with most of the points that Brendan raised. 6 months is too general a figure.

If you are a civil servant, you won't lose your job.
If you work for a bank and have years of service, you get the dole and probably 7/8 weeks for every years service.
If you work for a small business, you get statutory redundancy.
If you are self employed, you get nothing.

Everyone must assess their own situation, job security, family situation, housing situation etc.

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

 

[Sarenco]

Comparing the reserves of an insurance company is totally inappropriate. An insurance company has a predictable outflow of cash.

We are not talking about short term liabilities here. I have always said that equities are not appropriate if you are planning to spend the money in the short term. We are talking about a potential liability that is unlikely to arise. It might happen. It might actually happen at a time when the stockmarkets have just fallen. It may even happen after just after the stockmarkets have just fallen, just after a previous fall. You need to balance the definite savings in mortgage interest vs. the potential need for an emergency fund.

I would have thought that an emergency expense is by definition a short term liability. It may be an unplanned for expense but it still has to be discharged in short order.

The predictability of insurance claims largely determines the extent of an insurer's reserves. The need to be in a position to liquidate assets at or close to a certain price within a short period of time in order to meet claims determines the nature of the assets in which the reserves are invested. I am certainly not suggesting that individuals should model their finances on insurance companies!

I agree, however, with your final comment about balancing the need for an emergency fund with discharging debt (including relatively expensive mortgage debt). I certainly wouldn't advise anybody to hold more than 6 months worth of expenses as an emergency fund while they have expensive mortgage debt outstanding. Others may reasonably strike the balance elsewhere.

 

[Sarenco]

Yes, people compartmentalise their money all the time, it makes it easier to understand...that is for emergency, that is for education, that is for pension etc.



When deciding on the level of emergency fund required, I agree with most of the points that Brendan raised. 6 months is too general a figure.

If you are a civil servant, you won't lose your job.
If you work for a bank and have years of service, you get the dole and probably 7/8 weeks for every years service.
If you work for a small business, you get statutory redundancy.
If you are self employed, you get nothing.

Everyone must assess their own situation, job security, family situation, housing situation etc.

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

Fair point.

I would personally regard a 6-month emergency fund as the minimum amount that would be prudent to set aside before investing in more risky assets outside of a pension wrapper but I take the point that the precise amount should be dictated by individual circumstances.

For the avoidance of doubt, I would not consider pension contributions to constitute expenditure for this purpose - such contributions clearly constitute long term savings.

 

[Gordon Gekko]

I'm a great believer in keeping some cash (maybe €10k) in a credit union, as it should give you access to a bigger sum in case of an emergency.

That was the case, even in 2008/2009 when the pillar banks may as well have been closed for business.

 

[Brendan Burgess]

Hi Gordon

I have copied your post to this thread from the other thread as I think it's a very good point.

The credit unions are desperate to lend although their loans are very expensive.

But if someone is earning in excess of their expenditure, they don't need that big a rainy day fund. If they have an account with the credit union, they should be able to get a loan fairly easily. Then they can pay it back quickly out of their earnings.



Brendan

 

[txirimiri]

The former.




Well, I think it would be crazy for any household to spend €6,000 per month, in the absence of exceptional circumstances, regardless of their income - but there you go.

Try having a tiger era mortgage and more than one child in crèche plus health insurance, home insurance, life insurance, car insurance, waste changes, LPT, water charges, electricity, gas, food and clothing for a family of 4+, TV licence, broadband etc etc! Not hard at all to spend 6k a month unfortunately

More broadly, Brendan says that the correct response to an unexpected loss in income due to job loss etc is to reduce expenditure ergo a 6 month rainy day fund is not needed. Having experienced redundancy in the family, that's easier said than done. If you are already a careful budgeter and have made sure you are already on the best value health insurance plan, broadband, car, life and mortgage insurance etc the only expenditure you can easily further cut is food which, unless you are already spending wildly, doesn't yield a huge saving. Cutting out things like mortgage and car insurance or LPT, water, waste and TV charges is illegal; cutting health insurance exposes you to potentially large costs in the future when you want to buy back in. You can turn down the thermostat and save a few quid that way but, again, if you've been careful with electricity and gas use anyway, savings are minimal. Ireland is an incredibly expensive place to be law-abiding in ...

 

[Sarenco]

Hi txirimiri

I don't doubt for a second that it is not hard for a family to burn through €6k a month but I still think that's a crazy level of expenditure for any household.

That requires an after-tax income of €72k per annum - the vast majority of households in Ireland wouldn't have anything remotely like that level of disposable income after the taxman has taken his cut.

I think your points regarding the limits of reducing expenditure following a sudden loss of income are well made.

I still think that building a cash reserve equivalent to 6 months' average expenditure before paying down a mortgage ahead of schedule or investing outside a pension wrapper is the right approach for virtually everybody. I know Brendan thinks that is ridiculously conservative advice but I'm sticking by my guns on this one!

 

[Gordon Gekko]

Just revisiting this point via this original thread.

When people talk about having six months’ worth of expenditure, presumably that excludes things like AVCs, savings, discretionary spendand mortgage overpayments?

So it’s just what it takes to keep the show on the road, e.g. mortgage/rent, food, utilities, etc?

Gordon

 

[Sarenco]

Well, AVCs, (after-tax) savings and mortgage payments ahead of schedule are all forms of saving - not expenditure.

However, I wouldn't exclude discretionary spending from the calculation of your average expenditure.