How to Build an Emergency Fund? A Non-Obvious Take

When you begin your adventure with saving, a question comes up: what to invest in? Before you start your adventure with investing, though, according to personal finance theory you need to build yourself a financial cushion. That cushion is an emergency fund, amounting to 3 to 6 times your monthly expenses.

After all, there’s no alternative to the sense of security that comes from knowing you have cash stashed somewhere that you can always access. Sounds reasonable, right? Maybe it does — but anyone who has built an emergency fund will tell you that…

---

Easy to say, harder to do

A growing number of experts have doubts about whether you should build a financial cushion in the form of a specially set-aside fund available at any moment.

An approach that for twenty years enjoyed huge recognition — among the academic community, financial advisors and bloggers dealing with personal finance alike — is being questioned more and more often. But this isn’t about condemning protecting yourself against sudden expenses.

The point is that simply accumulating an emergency fund may not provide as much security as is commonly believed. This is money that has to be constantly available, yet it’s rarely used. The need to keep these funds constantly on hand greatly limits the range of options for where to put them.

What’s more, building an emergency fund will delay the start of investing. Another issue is that very often the mishaps that happen far exceed the financial cushion. But let’s look at this more closely.

---

---

Let’s start from the beginning: how to build a financial cushion?

Before you start thinking about investing, it’s advisable to first think through the matter of risk management. An important element of a financial protection strategy is the emergency fund. To build it, you need to answer five key questions.

If you have your financial plan, the answer won’t be a problem. If you don’t — you first need to delve into, think over and put into practice the fundamentals of personal finance.

1. What are your monthly expenses?
2. What can happen to you (what risks are you exposed to)?
3. What is your value on the job market?
4. What assets do you have and how liquid are they?
5. What is the opportunity cost of delaying investing?

Once you’ve answered them, it’s time for one more important question.

---

Are you ready to build an emergency fund?

First, paying off debts whose interest rate exceeds the rate of return on investments you expect to achieve. In most cases these are used overdrafts on accounts or credit cards and cash loans.

There are, however, also people who don’t tolerate financial risk to the point that even a mortgage counts as such debt for them. Although this rarely happens among people with developed financial awareness — such a total aversion to loans is associated rather with a lack of financial knowledge, and in particular a lack of knowledge about how loans work.

Once you’ve taken care of paying off high-interest debts, make sure you’re adequately protected against the risk of accidents and illness. A well-constructed investment strategy should be carried out in line with your financial plan.

If you’re suddenly forced to dismantle your portfolio because you urgently need money for treatment — all the effort will go to waste.

Not only will you fail to reach the goal set in your investment strategy, but it’s even possible that you’ll take out less money than you put in. So don’t combine investing with financial protection: some instruments protect against risk, and others let you build wealth.

Treat insurance as the foundations and investments as the building. It would be a shame for a luxury residence worth 2 million to collapse because you skimped on 50,000 for the screed, right? That’s why, before you start building an investment portfolio worth several hundred thousand zlotys, protect yourself properly — not only against financial risk, but also economic risk.

Debt repayment done, you’re now protected against the basic risks, so now you can build your financial cushion. Because this is the best way to protect yourself against financial risk: economic crises, job loss and other risks that are hard to predict and not covered by insurance.

---

Or a credit card instead of a financial cushion?

Before you start, though, it’s worth taking a look at an alternative solution: the „emergency” credit card. The idea is that instead of saving for a rainy day, you take a credit card that you’ll be able to use on that rainy day. On the face of it, an emergency credit card seems more expensive than a financial cushion, but it’s worth a closer look.

Keeping 15,000 PLN in a deposit yielding 3% gives you 37 PLN of interest a month. A credit card, in turn, means not only no interest, but sometimes a cost too. You can easily find free credit cards, but there are also banks where they cost 5 to 20 PLN a month.

Thirty-seven zlotys is still a small difference, although even that amount will, after three years, come to over 1,300 zlotys. The real problem, however, appears when you have to use the „emergency” credit card. Then even a free credit card stops being free — because interest appears.

The story of Damian’s snowboarding accident

Meet Damian. Damian is a salesman at a prestigious furniture showroom and, in his private life, a snowboarding fan. At work he has to look good. In February, while zipping along on his board in Zieleniec, a teenager cut him off. He braked dangerously, sprained his ankle, but worse — he knocked out one of his upper front teeth.

Damian is well protected financially — he has a life insurance policy (sum insured: 300,000), one for serious illness (100,000) and one for the consequences of accidents (100,000). The insurer determined a 1% bodily injury and paid out 1,000 zlotys in compensation.

Damian can’t afford a filling in a visible spot; he always took care of his teeth and is sure that a beautiful smile is responsible for half of his sales. So he has to put in a high-quality implant, which costs him 6,000 zlotys. Rehabilitation of the sprained ankle costs 800 zlotys in total.

So Damian has to bear 5,800 PLN of the costs of this accident out of his own pocket — and all within two weeks, so he can return to work as soon as possible.

The emergency-fund scenario

Damian has a financial cushion of 15,000 zlotys. Since he’s financially aware, he estimated his risk tolerance and decided that safe investment funds (risk class 1) are ideal for holding funds you need easy access to. He withdraws part of the money from his investment fund and, two days after the accident, gets to work on the tooth treatment and ankle rehabilitation. The following month he withdraws an additional 300 zlotys to make up for the missing bonus he doesn’t get while on sick leave.

Thanks to this, Damian’s lifestyle doesn’t change at all. After returning to work, Damian reduces the contribution to his medium-term investment program by 200 zlotys and puts the money toward rebuilding the emergency fund. After 31 months the fund is rebuilt.

The emergency-credit-card scenario

Damian has a credit card „just in case”. He pays for the tooth treatment and ankle rehabilitation with it. The following month he leans on it to keep his standard of living at the current level (300 zlotys).

After returning to work, he spreads the card debt into installments and reduces the contribution to his medium-term investment program by 200 zlotys. After 37 months he pays off the card debt (36 installments of 200 zlotys and one installment of 112 zlotys).

So which is better, an emergency credit card or a financial cushion?

In this case, the additional cost of using the credit card compared to the financial cushion is 1,212 PLN.

As you can see, the decision about how to protect yourself against mishaps requires calculating not only how much a given option costs per month, but also how much it will cost to have to use that protection. In this case the safety cushion turned out to be more cost-effective from a financial standpoint, but that’s not always the case.

Unfortunately I ran out of room in this article, but to compare the two solutions properly, you also need to think carefully about opportunity cost.

To build a financial cushion, you have to set up your financial plan properly. If your financial strategy assumes a weighted-average interest rate of 8%, then putting a dozen-odd thousand into instruments yielding 3% is a significant opportunity cost. Remember that the value of money falls continuously, and a 3% rate really only allows you to maintain the value of your capital.

In that case it turns out that the money in the emergency fund doesn’t give you 37 zlotys a month (nominal interest), but costs you 63 zlotys a month in lost interest. Because, after all, you could put that 15,000 into your investment program and, instead of 37 zlotys, have 100 PLN a month. In that case the credit card comes out cheaper.

Since the financial cushion’s advantage over the credit card is 1,212 PLN, you can easily calculate (1212/63) that if you expect a mishap more often than every 19 months, it’s better to build a financial cushion; if, however, such mishaps happen to you less often than every 19 months, it’s better to use the credit card.

What happened here? Well, opportunity cost happened. If you’re encountering this concept for the first time, in this article you’ll find out what opportunity cost is.

---

How big should an emergency fund be?

What risk do you want to protect against?

Nowhere is there as good data on unemployment as in the States. Since the Department of Labor began collecting data (and that was in 1948), the average duration of unemployment oscillated between 10 and 20 weeks (a minimum of 7.1 in July 1952). Right up until the 2008 economic crisis. In the summer of 2011 the average shot up to 40 weeks.

Everyone has to assess for themselves how long they can remain without work, but statistical data is a huge help. This US data, which says that for most of the period studied average unemployment was between two and a half and five months, became the basis for determining that an emergency fund should allow you to get by for three to six months.

It’s worth remembering that the above data is based on an average. Translating this into Polish reality, a PHP programmer from Kraków will pull the average down, while a tailor from Zielona Góra will pull it up. The more sought-after your skills are in the current economy, the shorter the period you can take into account when calculating the size of the emergency fund you need to build.

Similarly: the higher your expectations, the longer you’ll look for work, and so the higher your emergency fund should be.

How to calculate the size of an emergency fund?

To quickly calculate what size of financial cushion you should build, you can use David Weliver’s calculator. But any way you look at it, a calculator isn’t needed here at all. You simply have to multiply your monthly expenses by the number of months you’ll be looking for work.

Are you sure you want to use your own capital?

Liz Pulliam Weston believes you shouldn’t rule out credit cards upfront as an alternative to an emergency fund. Building a financial cushion worth three months of expenses can take several years. It also involves a high opportunity cost: instead of investing, you have to save using rather ineffective instruments.

And even if the emergency fund is ultimately to consist of easily accessible cash, Ms. Weston suggests using a credit card as a temporary safeguard until the emergency fund has been accumulated.

David Chilton goes further, writing in „The Wealthy Barber” that he’s not against emergency funds, but in his view it’s better to accumulate 2,000–3,000 dollars rather than 10,000. If, on the other hand, someone is afraid of larger expenses, they should protect themselves with a credit card or an account overdraft of 10,000.

Research has, after all, shown that most temporary financial problems required reaching for only part of the emergency fund.

---

What’s the right answer?

The right answer is the one you give yourself. Because there’s no universal solution for everyone. What’s certain is that investing can’t be your first conscious contact with personal finance. You have to start with preparing a budget, drawing up a balance sheet, setting goals and analyzing risk, and then saving.

The title question is very important. And everyone who wants to invest has to answer it. It’s not simple, because we stand between two valid arguments: on one side our desire to invest right now, this instant; on the other the need to protect ourselves against risk.

Take into account the power of compound interest and the fact that time doesn’t stand still. The earlier you start, the better; time has an enormous impact on the growth of your capital. Besides, maybe not everyone should unconditionally build an emergency fund?

Why put all your savings for several years into a 3% deposit when you can invest in more effective instruments — such as funds, real estate or shares? Sudden expenses are rare, and their actual cost is unpredictable. You can’t assume that an emergency fund worth even twelve times your expenses will manage to cover them.

On the other hand, though, think about the unexpected expenses that have happened to you or your friends. From an unexpected root canal to car trouble. Define your own risk of losing your job. Would you want to call around family and friends in an emergency?

Whether it’s better to build an emergency fund the traditional way and devote a year to it — a year in which you could already start investing — or to protect yourself with a credit card, is a really hard question. The final answer should be your own compromise between the one side and the other. And, on top of that, a very well-calculated compromise.