I’ve stated on this blog before that I don’t have an emergency fund. I look to my passive dividend income to effectively play that role for me. Its one of the less obvious perks of having a dividend income stream.
Emergency funds are a very important idea however. The concept is that they provide you with a buffer in the event that you meet with an unexpected event such as temporary unemployment or illness and allow you to quickly get back on your feet.
What you are effectively doing by having an emergency fund is self insuring your risk for these unexpected events. Its suggested that you should keep close to 6 months of expenses in an emergency fund. For an average family, that could mean close to $20k just tied up and sitting around, waiting for an emergency to happen.
That’s a big drain on capital that could be invested elsewhere. How big exactly? Well assume that $20k was able to be deployed in a 5% dividend producing stock and reinvested.
Over 5 years your $20k capital would have grown to a little over $25k, in 10 years over $32k. In 15 years you would have likely doubled your initial $20k.
So that unused emergency fund? Over 15 years it could end up costing you thousands in lost earning potential.
What are the alternatives? There was a very thought provoking article published by Brick by Brick Investing about using credit card debt in an actual emergency to get you through such a period, without the need for an emergency fund. I think this article was in the right spirit. As we’ve seen above, having an emergency fund just sit there idle in your bank account represents a huge opportunity cost, and there is a lot of merit for considering alternatives.
Of course, in some situations using very expensive credit card debt to help you get through an emergency may make your problem worse. The post did get me thinking about whether there may be other practical alternatives to holding a huge chunk of capital in a bank account earning you negative interest.
So what are you really covering with an emergency fund?
I think you have to be clear here about the specific risks that you are trying to protect. Frankly speaking, if you are looking to cover a long term event like long term employment or a critical illness, no emergency fund is going to do you justice (unless you have several hundred thousand in there)
In my view, I think there are probably 2 big things.
1) Short term Unemployment
2) Short term Illness
Unemployment – If you happen to lose your job, many companies provide you with a severance package. In some case this can be up 1 months pay or even more. Now i also know many states in the US do have some degree of unemployment coverage if you happen to be unemployed for a longer period . For those that need more, private unemployment insurance could help cover that gap. For as little as $100 a month, you can get up to 50% of your income covered from a place like Income Assume.
Short term Illness- Depending on your employer, you may find that you already can get some coverage for short term and long term illness. I know in many of the places that I’ve worked previously, you have short term disability coverage for an initial period of 1-2 months which kicks over into long term disability coverage after that. Even if you aren’t lucky enough to have such coverage from an employer, you can again get supplemental insurance to cover this. Places like Metlife allow you to obtain short term disability coverage for about $100/mth.
After you review of your existing coverage and what you are actually trying to protect, you may determine that you don’t need insurance coverage. What should you do with that surplus income? Invest it in dividend producing stocks!
As we saw above, reinvesting your $20k capital base in a dividend producing stock providing a 5% return can double your capital base to $40k in 15 years. Not only will you have a more than sufficient emergency fund at that point, but you’ll have an asset thats delivering you an ongoing income return.
What are my takeaways here?
1) Be clear about what you are insuring or trying to protect with an emergency fund – If you’re trying to cover a long term event, you may be overestimating what your emergency fund can do for you.
2) Be Aware of other options -If its a short term event that your trying to cover, and that event is unemployment or short term illness, then review your coverage with your employer. You may already have coverage for the exact event you are building up your emergency fund for. Look at private insurance options that come with much less “upfront opportunity” cost
3) Build up passive dividend income- The emergency fund problem is another reason why building up a passive dividend income stream is valueable in my opinion. Not only does it help get you to financial independence faster, but it can act as a buffer so you don’t have to tie up your capital self insuring yourself for these types of events.