Do you really need an emergency fund?
Zach Holz analyses different schools of thought on this financial safety net
An emergency fund stores cash for emergencies. Yes, you need one. See, that was easy.
But wait, if it's really that simple, why do they cause so much controversy in the personal finance world? And if you have one, how much should you keep in it?
There are various answers to these questions which I will outline, as well as offering a solution that could be useful no matter where you are in your financial journey.
Having an emergency fund can be the difference between paying an annoying bill and going into debt with a high interest rate that sucks up more and more money.
For a long time, personal finance experts such as Dave Ramsey and Suze Orman in the US have told everyone that the first step towards taking control of your finances is to build up an emergency fund. Many recommend having around Dh3,600 in a current account for those “just-in-case” situations like your car breaking down, the AC not working or a family member going into hospital unexpectedly. This is because many people across the globe live paycheque to paycheque with no savings, leaving them one unexpected expense away from disaster.
When people are in this situation, having an emergency fund can be the difference between paying an annoying bill and going into debt with a high interest rate that sucks up more and more money. Worse, you could even end up unable to pay your mortgage or car loan or your children's school fees. People have gone homeless for less.
Therefore your first priority needs to be setting aside that small sum of money, even if you consider your credit card as your back up. Credit cards in the UAE come with extremely high interest rates of around 45 per cent per year, and if you put a sudden, large bill on it and can’t pay it off, the situation can quickly spiral out of control. That sort of debt can keep you trapped in the country.
Once you have built up your Dh3,600 emergency fund, the next step is to have between three to six months of expenses in cash. This allows you to live for an extended period of time without a job. Any money saved beyond this goes into buying investments such as stocks, bonds and real estate. For many, having this pot set aside offers a sense of security because they know they will be OK for quite a while if something happens such as losing a job or an extended illness. It can also motivate people to take calculated risks like changing careers or leaving a terrible job.
At the other end of the spectrum, however, is Mr. Money Mustache, a popular US personal finance blogger, who says you don't usually need an emergency fund. In his YouTube video MMM vs The Emergency Fund, he argues that emergency funds stop your money working for you.
Once people get out of debt, he says keeping money in a current account offering zero interest is just harming your future wealth. As long as you save a considerable amount of your monthly salary, like 30-75 per cent, then any emergencies can be paid for by what you would normally save. If there’s an emergency beyond that, Mr. Money Mustache recommends paying for it by selling stocks or bonds.
For me, the answer to the question of “do you need an emergency fund?” depends on where you are in your journey, and how much monetary comfort you need to sleep well at night. Personally, I keep a year of expenses in cash, because that’s where I feel comfortable. But it’s a year of expenses for living in a very inexpensive country, like Thailand, where I’ve calculated I can live for about Dh30,000 for 12 months. Is this the mathematically “correct” answer that maximises my returns? No. But I also know I have another Dh36,000 available on a US credit card, if push came to shove, and that makes me sleep even better at night.
Like many, I don’t like the idea of losing my job in an economic downturn at the same time my stocks and bonds are also losing value forcing me to then sell them at a loss to cover my expenses. I don’t want to sell assets in a downturn if I don’t absolutely have to.
Is that how you feel? Maybe. Maybe you like to live more dangerously or have other expenses I don’t have. But you need to ask yourself what you’re comfortable with — what the balance is between maximising your returns and sleeping soundly at night. At the very least, have easy access to some cash, preferably in multiple countries and bank accounts in case something goes wrong with one of them.
Hopefully, you’ll never need it, but if you ever do, you’ll be very glad you were prepared.
Updated: September 19, 2019 03:41 PM