Friday, April 21, 2006

What do you really need in your 'emergency' fund?

The question came up this week in a chat area I frequent: When do you declare your emergency fund full? Financial pundits like to throw around suggestions about 'have three/six/eight/a bazillion months of cash on hand,' but what are people really setting aside as a cushion?

Here's an article on the topic I like: The $0 emergency fund. The author's argument is that these days, with easy credit and all sorts of savings and investment options available to regular consumers, what you really need isn't cash but flexibility.

Jonathan Clements of The Wall Street Journal drew a lot of heat a few years ago when he confessed to keeping only a month's worth of expenses in his emergency fund. He wanted his money working for him in the markets, not disappearing inch by inch as taxes and inflation took their toll.

But Clements' view is shared by many financially sophisticated folks who would rather take more risk -- in stocks, in real estate, in their own businesses -- to get better returns. And that approach can be perfectly legitimate, as long as you can quickly get your hands on enough money when you need it.

This makes a lot of sense to me. A 'real' emergency -- a job loss, a medical crisis, draconian rent hikes, etc -- is something that throws your usual life into chaos. You can't effectively plan for such things. What you can do is give yourself as much flexibility as possible. Having lots of savings is a great cushion for all sorts of unexpected life events, but you don't really need all that much sitting in a basic checking account or stuffed under the mattress in $20 bills.

There are a number of savings/investment options that give you near-immediate accessibility to your money, like money-market accounts or straight stock-trading accounts. A level up, there are vehicles like short-term CDs. I just checked my bank's rates, and the rate difference between a 1-year CD and a 5-year CD is less than 0.10%. With so little incremental difference, there's no reason not to opt for the shorter duration and have your money more liquid.

The real decision point comes when you're considering tying up your funds in something difficult to quickly liquidate -- like real estate or a business venture. There, I think the 'flexibility' comes into play. The investment may eat up an uncomfortable share of your 'cash' savings, but: do you have other ways of tapping cash if you need to, like lots of available credit, a home-equity line, a 401k loan, and so on? So long as you *can* get three/six/eight/a bazillion months of available money if you need -- and everyone will have to come up with their own comfort-level number to fill in that blank -- it doesn't seem essential that the money actually be cash.

So what's my own emergency-fund strategy? I'm trying to save up about $5,000 to put in a money-market account, where I can grab it instantly if needed. I have a significant chunk of available credit -- enough to pay most of my living expenses for about six months, I think. And I have about an equal amount available for borrowing against on my 401k.

My next 'major' cash-immobilizing purchase will likely be a primary residence. If we eventually get there, I expect the down payment to devour any 'emergency fund' savings we've accrued, but I won't fret too much about it as long as we have credit levers we can pull if needed.