If you follow the traditional financial advise, the recommendation is to have an emergency fund that will cover about three to six months of your monthly expenses. This recommendation is great for someone who doesn’t live below their means, but is an emergency fund really necessary for someone who lives frugally and lives below his/her means? Sandi just wrote an interesting article at Boomer and Echo that covers this topic. Her article makes me ponder if an emergency fund really is necessary.
Why Emergency Fund is Necessary (for the average Joes)
If you’re an average Joe that doesn’t have a monthly budget or doesn’t live below your means, you absolutely do need an emergency fund. When you’re spending as much as your monthly income, any surprises in life could put you into debt. Imagine that you take home $3000 a month and you spend $3000 a month. There’s no deficit but there’s also no buffer. Now imagine getting into a car accident and having to pay for your insurance deductible of $300. Since your take home income is exactly the same as your monthly expenses, you don’t have any money left over to pay for the insurance deductible. What do you do? Maybe you put the $300 amount on your credit card for the time being. Guess what, since there is no buffer in your financial lifestyle, you won’t be able to pay your credit card amount in full, forcing you into paying the high credit card interests. It may take you months to pay off your new credit card debt. If this is your financial life style, you absolutely need an emergency fund to cover any financial surprises.
Do you really need an emergency fund?
What happens to someone who lives frugally, has a monthly budget system, and lives below his/her means? Is an emergency fund really necessary? In this situation, I believe you can have a smaller amount saved in the emergency fund. How small will depend on each individual and his or her saving rate. Take the car accident example again, say your monthly income is $3000 but you only spend $1500 each month. You have a 50% saving rate and a built-in $1500 buffer each month. If you have an unforeseeable expense, like the insurance deductible, you already have the money. There’s no need to get into credit card debt because you can easily pay the amount in full. When you have a monthly saving rate of 20% or more, you’re building a good buffer for yourself. If you’re in the extreme case and have 50% saving rate or more, you probably won’t need an emergency fund.
In today’s low interest rates environment, having three to six months of monthly expenses sitting in the bank earning 1% or less interest rate just makes no sense. You’re better off investing that amount and have your money work hard for you at a higher rate. This is why I love dividend stock investing so much. For us dividend investors, the dividend received each month can also be considered as our “emergency fund.”
How Emergency Fund Works for our Household
How does this work for our household? We live below our means and have a good monthly saving rate. Part of our money management system forces us to put some money aside each month into an account called “Long Term Savings for Spending” (LTSS). This is the money we’ll use for vacations and other big item purchases. The rest of the money saved will go to purchasing more dividend stocks. In a way, the money saved in our LTSS account can be treated as the emergency fund. If we were to spend that money, it just means that we won’t have a vacation this year. Furthermore, Mrs. T and I both have maximized our TFSA and invest all of our TFSA capitals in dividend paying stocks. We also have dividend stocks in regular accounts. The dividend that we receive each month in these accounts can be used in emergency situations. In addition, we have a small amount of cash reserve that we don’t touch. That amount used to be over $10k but we’ve been slowly moving that cash reserve for dividend investing because our monthly saving rate has been going up. A high saving rate means that we are building even more buffer each month.
In summary whether there’s a need for an emergency fund depends on the individual. If you’re responsible with your finances, you most likely only need a small emergency fund or none at all. If you’re financially irresponsible, you need all the help you can get.
What about you? Do you have an emergency fund?
In case you’re wondering, Mrs. T and I do not call it an emergency fund. We believe what you focus will expand. Instead we call it an opportunity fund.