How much Cash do I really need for emergencies?
Last month, I had an unexpected cash scare: my bank sent me an email notification that I had "insufficient funds" to process a payment of about $800, and that if this was a check there may be an overdraft fee applied to my account. I was scared, especially because I had aggressively invested most of my available funds into my taxable brokerage account and if I added up all of the cash available in my liquid checking and savings accounts they totaled to less than the $800 required to foot this cancelled payment. I was even more concerned because days ago, I refinanced my mortgage, and the personal check I brought to closing was about the same amount. What if I jeopardized my mortgage refinance?
My immediate steps were to reach out to my mortgage broker, humbly accept my boyfriend's offer to quick-lend me $1K, and figure out what happened. It turns out that my mortgage refinance check had gone through (phew!). The insufficient funds payment was associated with my estimated quarterly tax payment to the state, and I had set up automatic payments on a quarterly basis with the understanding that I would have at least $5K in my savings account as an emergency fund on a regular basis. Except, I didn't!
Since we are dropping down to a single income in a few short months, I recognized the need to keep some cash lying around for emergencies since my boyfriend will be a full-time college student and unable to bail me out. But how much do I really need to hold in cash?
How much do I need?
Most financial advisors will recommend holding anywhere from 3 months to 18 months worth of essential spending in a risk-free emergency fund, with the majority recommending 6-12 months. The general idea behind an emergency fund is that is self-insurance against unexpected expenses, job loss, disaster, etc. As someone who grew up in a "live paycheck to paycheck" environment, I still remember the financial stress and turmoil of not having enough for an unexpected medical bill, broken appliance, or car repair that quickly morphs into all-consuming stress as one thinks of how to pay for it. I relived this stress a few years ago as a graduate student making about $20K/year.
In recent years, I have been fortunate enough to boost my income to the point where I can cash flow a good amount of unexpected expenses, however, my overall living expenses have also increased substantially relative to my grad school days. I also feel the "pain" of having too much cash sitting around rather than putting it to to work in the market. I needed a more complex perspective to understand how to think about emergency funds rather than a simple rule of thumb. My favorite resource on this topic is a Vanguard article called: "Break glass in case of emergency: Managing household liquidity." The Vanguard article breaks down three key points to consider when saving for emergencies:
Understand financial shocks: Spending shocks vs. Income shocks
Set aside cash for common spending shocks
Balance risks and long-term goals to mitigate income shocks
My favorite chart from the Vanguard article is the following, which gives a more specific breakdown of thinking through how much cash a household might need to set aside for emergencies:
I love this chart from Vanguard because it helps me think through how my personalized needs may differ from the average, and it gives me a framework for assessing these dimensions. Luckily (and through a lot of hard work),
Job Skills: I have a skill set that is in high demand across multiple firms and industries,
Job Security: my job security is high with my current employer
Insurance: my current employer provides generous insurance policies, including a life insurance policy that guarantees my spouse half my salary for 10 years, should I unexpectedly die
Alternative Financing: my home equity gives me the option to open a home line of equity; I'm working towards building up the amount in my taxable brokerage account to be able to access it on margin; my boyfriend and I have healthy credit scores that would enable opening up 0% intro APR credit cards.
The points of vulnerability for my boyfriend and me from September through December will be
Income: Single earner
Spending flexibility: Between two mortgages, HOA fees, insurance, and college tuition, our required monthly spending will be high. We still have wiggle room in our spending of about $1K.
With all that, here's what the same chart looks like for me and my boyfriend, beginning in September:
Our Household Spending
After reviewing the last few months of expenses, I have a pretty good understanding of how much we spend on a monthly basis, and how that breaks down between Essential Spending vs. Actual Spending. If we really wanted to, we could cut down on fancier meals, family gifts, and nonessential home improvement projects. Our two key vulnerabilities that would require an emergency fund would be a large unexpected expense (e.g. home improvement or health scare) or job loss on my part. I am way too practical to ever rage-quit a job without having a backup plan, and I feel confident that my company would give me at least 6 months of advance notice before firing me for performance reasons. Even if I were to lose my job, I could count on a combination of Unemployment Insurance and credit cards to account for half of our Essential Spending.
How much risk can I take?
The Vanguard table considers how much exposure to market risk a household's assets have as compared to cash. Taking into account my estimates for different ranges of emergency amounts I should have for coverage, asset allocation is the key area I want to focus my planning.
I currently have about $30K in a taxable brokerage account mostly invested in a total stock market index and effectively $0 excess cash set aside for emergencies. I also have at least $100K in Roth IRA contributions made over the years via my annual contributions (direct or through a backdoor) and Roth rollovers from former employers' Roth 401K plans. If an emergency were to hit today and I lost my job and the stock market crashed 50%, we would still have enough in my taxable brokerage and Roth IRA contributions to draw down 2 months' worth of actual spending and college payments. If I lost my job today and the stock market stayed flat for a year, we would have 7 months' worth of actual spending and college payments covered.
Hopefully that doesn't happen. I'm writing this on a weekend, so it is pretty difficult to get fired on a weekend anyways :) In planning for the future though, I really want to avoid having to take money out of my Roth unless it was truly an unavoidable emergency, since any money taken out of a Roth account cannot be put back in.
My goal is to have 6-12 months worth of an emergency fund, however, I would like to work towards a goal that allows my money to work for me. If we were to simply sock away a lot of cash, $32K in cash would give us 5 months' worth of total expenses in the event of a 50% drop in the stock market without having to touch my Roth IRA, and 11 months' worth of expenses if should we dip into my Roth IRA. If we were to cut our spending down to the bare essentials, $32K in cash would last us between 9-18 months in a 50% market downturn, and 11-29 months without any downturn.
It's hard for me to think about having $32K just sitting around in cash. I know that the more I have invested in the total stock market index, the more access I have to alternative financing through margin loans, which lowers the amount of liquidity needed for an emergency fund.
Here's another approach that puts more weight on building up an excess emergency fund with higher risk. By saving $15K in cash and $35K in the stock market, we can get a similar amount of coverage for emergencies without sacrificing investment growth. This gives us a range of 5 to 11 months of emergency fund coverage should the markets tank 50%, and 9 to 20 months of coverage should the markets stay flat, depending on how much we want to draw down on the Roth IRA. If we were to drop down to essential spending only, this plan would give us anywhere from 9 to 33 months' worth of coverage.
I feel a lot better about the Investment Tilt Emergency Fund plan because it gives us the coverage we need for expenses in the case of an emergency, but at the same time does not sacrifice investment growth. However, it requires a larger portfolio size ($180K compared to $162K) for similar coverage as the Cash Tilt approach. As long as I am gainfully employed and we are able to maintain our budget, I feel confident that we will be able to achieve this level of coverage by the end of the year.