Why Skipping an Emergency Fund is a Risky Financial Mistake

Cash is King! Why does the king have so much cash, you ask? So he always has enough liquid $$$ in case of an emergency or opportunity. When implementing a properly designed financial plan, one of the first steps is to ensure you have an emergency fund.

This liquid account can be accessed without penalty and should have little or no volatility. The account should be held separately from your main checking account and only be accessed when an unanticipated event forces us to stretch beyond our normal budget.

Traditionally, financial planners call this short-term bucket an “Emergency Fund.” However, I like to label it as an “Emergency/Opportunity Fund” since it is not only for the “uh-oh” scenarios, but also the “I can’t pass this up” scenario. When we are liquid, we have the flexibility to take advantage when opportunities present themselves. Liquidity also prevents us from making financially foolish moves to cover unexpected debts that come our way.

According to a report by the Federal Reserve, nearly 40% of Americans would struggle to cover a $400 emergency expense without resorting to borrowing or selling assets. Having cash on hand allows individuals to avoid these financially hazardous situations.

Preparing for the Unexpected

The car needs repair. The furnace is broken. A trip to the emergency room. My company is downsizing. We all know the things that pop up throughout the year that throw us off track from our savings goals. These events inevitably need to get paid. Ignoring or postponing payment will end up costing interest and penalty or can even lead to collections or bankruptcy. This is exactly why we set up an emergency/opportunity fund.

Your alternative is to run up credit card debt, liquidate long-term accounts, or borrow money. Obviously, these are not financially prudent strategies, so having an emergency/opportunity fund to tap into allows you to side-step these potential pitfalls.

High-interest credit card debt, which often exceeds 16%, can snowball into unmanageable financial burdens. In fact, a 2022 study found that the average American household carried $6,270 in credit card debt. Having an emergency fund in place prevents the need to turn to such costly debt instruments during unforeseen events.

Seizing Opportunities: Flexibility with Your Fund

A business opportunity presents itself. Your child gets into a prestigious private school. A piece of real estate goes on sale way below market value. These are all opportunities that may be unexpected. Here is another perfect use for your emergency/opportunity fund. Instead of moving your illiquid or long-term assets around to scrounge up enough money to take advantage of these opportunities, use your emergency/opportunity fund and remember to refill your short-term bucket.

Beyond emergencies, maintaining liquidity also allows individuals to seize investment opportunities that require quick action. Charles Schwab's Modern Wealth Survey revealed that 64% of investors wish they had more liquidity during market downturns to take advantage of low prices.

Customizing Your Fund: Tailoring to Your Needs

Like all custom financial plans, a proper emergency/opportunity fund is different for everyone. The first step is to have a good understanding of your monthly budget. Make sure you take some time and are honest when mapping out your monthly fixed and discretionary expenses.

If you are in an extremely stable job with predictable income and a low threat of termination, your emergency fund needs to be 3-6 months of total monthly living expenses. If you are self-employed, commissioned, or have variable income with a higher threat of future unemployment, then your emergency fund needs to be 6-12 months of living expenses.

The COVID pandemic highlighted the necessity for flexibility in emergency fund sizes. Vanguard recommends that those with fluctuating incomes should set aside closer to 12 months of expenses to ensure adequate coverage for prolonged periods of uncertainty.

Ensuring Liquidity: Accessing Your Funds Easily

Your emergency/opportunity fund needs to be liquid. Liquidity refers to the degree in which your money can be accessed with the least amount of fees and penalties in the timeliest manner. The focus should be on the preservation of principal since you never know when you are going to tap into this account.

Your local bank should have savings and money market accounts. Generally, money market yields are slightly higher than savings accounts. They are variable since the bank is technically lending out your money as very short-term loans. However, they are considered a cash equivalent since they are liquid and focus on capital preservation. Those looking for more yield and willing to assume slightly more risk can look to a no-load short-term bond fund.

High-yield savings accounts offer competitive interest rates, often above 4%, making them an ideal option for emergency/opportunity funds. Bankrate's analysis shows these accounts provide liquidity while outpacing traditional savings rates.

Conclusion

The emergency/opportunity fund is the anchor of your financial plan. This should be a primary focus even before funding retirement, education, and other long-term goals. A properly funded and designed emergency/opportunity fund allows you to stay on track with all your other planning strategies no matter what life throws at you. So, make it a focus to be a cash king and fill up your emergency/opportunity fund.

The emergency/opportunity fund is the anchor of your financial plan. This should be a primary focus even before funding retirement, education, and other long-term goals. A properly funded and designed emergency/opportunity fund allows you to stay on track with all your other planning strategies no matter what life throws at you. So, make it a focus to be a cash king and fill up your emergency/opportunity fund.

Explore more about how an emergency fund can enhance your financial stability. Review your current financial plan, or learn more about setting up a fund that works for you by reaching out for guidance. Focusing on your financial readiness today can help provide the stability needed to face tomorrow's challenges with greater confidence

*Article published on 10/14/24*
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Disclaimers
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Money Market Fund: An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.

Daniel Aguanno is a CERTIFIED FINANCIAL PLANNER™ (CFP®) professional and holds his series 7, 66 registrations through both LPL Financial and Private Advisor Group along with his life and health insurance licenses. He works at the Bleakley Financial Group and can be reached at 973-575-4180 or daniel.aguanno@bleakley.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.