Let’s talk about money—but not the fun, exciting kind. Let’s talk about the kind of money you hope you never have to touch: your emergency fund. It’s that safety net, that financial cushion that allows you to be flexible and can prevent a minor bump in the road from turning into a catastrophic crash.
I often ask clients about how they would handle an unexpected emergency, and if they think the emergency funds they have set aside are sufficient. During our initial meetings we ask questions like, “Do you have money set aside for unexpected expenses?” or “What kinds of financial emergency do you think you may not be able to cover?” and “What if you lost your job?” Knowing this is crucial in understanding your overall financial health.
As you can see from the accompanying chart, households appear committed to saving for a rainy day. Checking accounts and currency held by households have risen to just over $4 trillion, a steady increase from less than $1 trillion in 2019.
Why Is an Emergency Fund So Important?
Imagine this: You’re cruising along, life is good, and then bam—your car breaks down, your roof springs a leak, or worse, you lose your job. Without an emergency fund, these unexpected expenses can send you into a financial tailspin.
From sudden job losses to costly home repairs, having a financial cushion can mitigate stress and prevent serious financial setbacks. Without adequate savings, individuals may find themselves relying on credit cards or depleting long-term investments, potentially jeopardizing their financial goals.
An emergency fund should always be the foundation of savings. Large aspirational expenses (things we want but don’t need) should not dip into your base emergency fund; they should be in addition to it. I know a couple who had to postpone their dream vacation when their home needed unexpected repairs (their air conditioner needed to be replaced). It was a tough pill to swallow, but it highlighted the importance of being prepared.
Where Should You Start?
Creating your safety net can be done in a number of ways, with the easiest being to ‘simply’ set aside a fixed amount on a monthly basis until you reach your goal. You can also help speed up the process by adding your tax refund, or a bonus you receive from work. As these windfalls generally fall outside of your monthly budget, saving them into your emergency fund should not impact your lifestyle and you will also not feel like you are depriving yourself of anything.
How Much Should You Save?
The general rule of thumb is to save three to six months’ worth of living expenses. But this is just a starting point. If you’re self-employed, have a variable income, or work in a high-risk industry, you might want to consider saving more. Upcoming events, like elections or potential recessions, might also warrant a larger emergency fund. For example, if you’re a tenured teacher, your situation may look different than a sales professional working at a start-up.
It’s also important to think about what constitutes an emergency. Sure, car repairs and medical bills qualify, but what about job loss or a significant decrease in income?
The Extended Emergency Fund
Another concept I like to introduce is the “extended emergency fund.” This is money saved beyond your core emergency fund for larger, less immediate goals without a specific timeline, like a down payment on a vacation home, a new business venture, or a dream vacation.
The key with an extended emergency fund is that having cash in the bank beyond a 3-6 month emergency fund can potentially be inefficient and create drag on your wealth-building over time.
For example, if you have an extra $50,000 in your bank account earning 0.5% for 30 years, you are missing out on a hypothetical $142,384.90 of growth if that would have otherwise been invested and growing at 5% per year.
With these funds, you generally want some growth potential but much-reduced volatility, so it remains flexible. One of the ways we aim to accomplish this by trying to ensure the money isn’t invested in something volatile—because if the market is down, you can realize your losses if you take the money out to spend it. Again, where you invest this portion of your money will vary depending on you and your goals. The sooner or more concrete your need for the money is, the more conservatively (think cash, money market, treasuries) you will generally want to invest it. The further out or looser your timeframe is, the more moderate to aggressive of an investment approach you may be able to take.
Using Cash Value Life Insurance as Part of Your Extended Emergency Fund
One often overlooked option for an extended emergency fund is the cash value from a whole life insurance policy. Whole life insurance policies accumulate cash value over time, which you can access for various needs, including emergencies. The beauty of using a whole life policy is that the cash value grows tax-deferred, and withdrawals can be made tax-free through policy loans, making it a tax-efficient way to supplement your emergency savings.
When looking to implement any advanced strategy like this, you need to be aware of how it works, along with any potential pitfalls. When you take money out of a life insurance policy in the form of a loan, if your policy is with a non-direct recognition company (as opposed to a direct recognition company), you will still pay interest on the loan you take out, but your policy will continue to grow as if the loan had not been taken out. Generally, the growth that continues in your policy can be higher than the loan rate, but that is not always the case, and depends on the individual policy and the insurance company. Also, unlike a typical loan, there is not a loan repayment schedule – you can put the money back into your policy when it best suits you, but it is generally recommended to at least pay the interest. Keep in mind that when you take loans from a life insurance policy, they reduce the cash value as well as the death benefit, and it may increase the chance the policy will lapse.
Unlike a typical bank account, where interest rates can fluctuate, but are generally low on average, the cash value in a whole life policy has the potential to grow at a higher rate, depending on the policy and insurer. This growth rate may surpass the returns on a standard savings account and has the potential to outperform bond funds over the long term, especially in a low-interest-rate environment.
Moreover, life insurance offers a significant advantage if the unexpected happens. If you or your spouse were to pass away, the death benefit from the policy could help fund your child’s education, cover living expenses, or ensure that your family doesn’t have to dip into your emergency fund just to get by. We still have the same hopes, goals, and dreams for our children, regardless of whether we are still around or not. Life insurance can help keep those dreams alive, even in the most challenging circumstances.
Final Thoughts
An emergency fund is more than just a safety net; it’s a tool for financial freedom. It allows you to make choices, not be forced into them. By prioritizing your financial security, you are setting yourself up to be in a position for long-term success.
If it’s been a while since we discussed your emergency fund, or if your emergency fund has grown well beyond the recommended 3-6 months, it may be time to revisit your approach.
So, take some time to assess your current situation. Do you have a solid emergency fund in place? Is it time to increase your savings?
