We need to talk. It's about your "Emergency Fund." Most believe you should have a reserve of three to six months of expenses set aside at all times in case of sudden unemployment, expensive necessary repairs, etc. Most new clients come to me with at least an understanding that they should have an emergency fund. And many even come with one loosely set up. But from there, I see a mish-mash of problems, missed opportunities, and misunderstanding. So let's take a look at some of the most recurring issues I address with clients when tackling their emergency fund.
Wrong Amount - A good emergency fund is usually about 3-6 months of expenses. But some expenses need not necessarily apply, such as retirement plan contributions or your Friday night movie tickets. Think about what your "bare bones" living expenses are and use that total. You don't want to have too large an emergency fund because you're not going to be getting the best rates of return on this account. Think also about the type of job you have and your living situation. A dual income, government employee with years of experience is not likely to lose his/her job and even if they did they could count on their spouse's income sustaining the family for awhile. Since it's less likely they'll ever lose their job unexpectedly, and have another income to fall back on if they did, they could err on the side of a smaller emergency fund. Conversely, an unmarried realtor could go a year between commission checks. Their emergency fund needs to be larger, perhaps up to 12 months of expenses.
Wrong Location/Type of Account - I see this more than anything else. A client arrives with tens of thousands of dollars saved in an account earning 0.05% interest. It breaks my heart. Many know there must be a better option, they just don't know what it is. For these people the solution is one of, or a combination of, two choices. First, an online, high yield savings account. These accounts are yielding around 1.90%/yr right now. Alternatively, you can open a brokerage account and invest very conservatively. Here, your rates of return should be around 3-5%/yr, albeit with some risk. Either of these options are far better than standard bank checking or savings accounts.
Not Considering Your Age - For those over age 59 1/2 I recommend, if possible, relocating your emergency fund into an IRA account. There's no point in housing funds in a taxable account now when you could get tax deferral or even tax free growth of those monies in an IRA.
Having an Emergency Fund When You Shouldn't - Here, I'm speaking to those who have dutifully compiled an emergency fund because that's what they were told to do. One problem - they also have high interest debt. There's no point in having an emergency fund earning 2-5% when you're paying 20-30% interest on a credit card. In the unlikely event an emergency does arise, you can always charge it to your credit card with the newly created available credit your extra payment has created. While not ideal, your credit card is still a resource. But emergencies are, by nature, rare occurrences. So why earn just a little return on an emergency fund when you are guaranteed to be paying a really high rate of interest on a credit card? Better to just pay down the credit card as fast as you can and then build your emergency fund.
Counting on a Home Equity Line of Credit (HELOC) as an Emergency Fund - This sounds good in principle, as you can avoid the low rates of return offered in most savings accounts and instead just tap accrued home equity. One problem, HELOCs are not guaranteed to be there when you need them. Most banks can "call" their HELOCs at any time. I've had clients share how their HELOC was called in 2008, just when they needed it most. They had to sell a property substantially below market value to pay off the loan. The lesson: don't count on a HELOC as your emergency fund.
Each situation is different and everyone is unique. You and your advisor need to think critically about your own situation to determine the best emergency fund for you.