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.
Definitely, a different idea for an emergency fund rather than the typical low interest savings account idea. Personally, I think emergency funds depend on your Budget/Salary/Net Income for each month.
My emergency fund is a credit card because all of my expenses are about 790 (before entertainment) and my Income is around 2000, therefore, I know that I can pay off a credit card bill for the following month due to my excess cash. However, i might need to have a general cash reserve soon if I become a home owner
Hi Mike,
Thanks for the comment. I think using your credit card to backstop your expenses for a month or so is possible in an emergency. The issue is if the emergency persists for several months. All of a sudden, you may have racked up several thousand dollars in credit card debt that incurs high interest. When you are trying to get over an illness or trying to find a new job, that can actually lead to major stresses . I think it all depends on what the emergency is and how long it lasts for, which none of us can sit here an predict at this moment (which is why we hope it never happens!). That’s why sizing a fund for several months of expenses is probably a good idea.
You’re spot on in terms of the factors influencing the size of the fund. With a mortgage and considerable childrens expenses, I’m going to need a much larger fund than someone who’s single. There are probably a few things that can be trimmed, but even still, I think I’d be running at least the $2500 that I estimated for family per month.
I agree. The emergencies that I can face in my life right now are going to be rather cheap since I dont own much such as a car or home. Therefore, my only emergency would be unemployment. Fortunately, my monthly bills would be lower than my income on unemployment. In addition, I have a cash reserve which I am saving for a down payment for a home that I would be able to apply to an emergency. Furthermore, if I was unemployed, I would not be too proud to take a job during the interview process such as waiting tables, retail, grocery.
Nevertheless, I believe that emergency fund is different for everyone and there are several proven methods that work including yours.
What are you thoughts on CSX?
Its funny you ask about CSX because I was just commenting recently on a post about NSC (Norfolk Southern). I have been interested in rail for a long time, Buffet really highlighted the category with his purchase of Burlington, but rail operators have solid regional moats.
It becomes hard and uneconomical to have competitive carriage once a rail operator is in place. The same things holds true for airports, quarries and even garbage depots (strange set of things to be mentioning together I know!). Rail additionally benefits from economic activity and higher oil prices (when you see a switch from road to rail). In my mind, economic activity is likely to go higher in the next few years, and with that, I think you have spikes in the oil price as well.
I need to put CSX on my list to look into further as well as NSC (I’d like CSX more if their yield was a little higher). But I’m a fan of rail, I think rail companies have solid moats and i like the play on economic growth. Thanks for bringing it to my attention.
Jumped 5% today.
Thanks for including me in your post!
I like how you illustrated just how much 6 months in expenses is for a typical family.
My pleasure Marvin. It was certainly a very thought provoking post on your site and credit cards are a possible way to self insure yourself for emergencies.
As you point out, for a family with a mortgage and kids, this is a sizeable amount of capital to have lying around. I think people need to rethink the way they have traditionally thought about an emergency fund. If you aren’t clear about why the fund is really there and what its purpose is, you may be over insuring yourself and may be doing yourself a disservice.
My emergency fund is designed to cover unemployment and major unexpected purchases. I work in a labile industry, so it’s always possible that I’ll lose my job. The economy is still pretty bad so I wouldn’t count on getting a new job in anything less than a year at this point. The other thing I worry about is my car. It’s old. It will give up the ghost one day, probably at the worst possible time. I want to be able to buy a replacement car immediately if that happens. Biking and public transportation aren’t really options here, so being able to get a new car immediately is a priority.
I agree that it’s a sizable amount of capital to leave laying around. And that doesn’t make me happy. But until I can generate substantially larger passive income streams, my emergency fund will have to stay on the large size.
My FI,
Fair point on the unexpected purchases. That’s certainly one thing that you can’t arrange alternative insurance for (and given how old your car sounds, it doesn’t sound like there would be any type of warranty coverage that could kick in for you!).
You may well have certain company and state provisions that can tide you over for a while if you get unemployed or laid off. Could be worth looking into that if you haven’t already. I do agree with your point that if you’re laid off in this economy you’re better off planning for an extended period, so touch wood you’re just overprepared and the emergency fund will never need to be utilized.
I’m with you. I couldn’t imagine keeping $20k around, waiting for something bad to happen to me. I think the only emergency in that case is the pitiful interest you’re receiving on your cash.
I keep around $3-5k in my checking account as my “float” to cover regular bills and as a slight cushion in case Murphy’s Law strikes. I also have over $10k in open credit available to me through three cash reward credit cards I use to make everyday purchases and then pay off. The passive income my dividend growth stock portfolio generates also acts as a bit of emergency cash if I absolutely need it. I can simply stop reinvesting it and take it out as cash. My own personal ATM machine if necessary.
Not only all that, but stocks are among the most liquid investments possible. In a true emergency one can simply sell a very small portion of your portfolio and get the cash fairly quickly.
Best wishes!
DM,
Thanks for stopping by!. The passive dividend income really helps out a lot here. Its not something that I previously ever thought would be a benefit of having dividend income, but avoiding opportunity cost in having your funds locked up at low rates is a definite added benefit.
The only issue with needing to sell stock to cover an emergency is if we happen to be in a 2008-2009 type situation, you’re really getting hit hard in terms of the proceeds that you can realize, but if you have significant assets in stocks, this shouldn’t be a problem.