Posted by: Daryl & Wendy Ashby | October 20, 2010

Emergency Funds

It is pretty much investing convention that a household should ideally set up an emergency fund of 3 – 6 months of fixed expenses. The question that rarely gets asked is when do you set up the emergency fund? Or, when do we pay down debt or build or augment an emergency fund?

“As soon as possible” or “always build and augment your emergency fund” is an ideal but sometimes impractical answer. For example, it would be nice for a 23 year old recent graduate to begin to accumulate an emergency fund. Problem is that most 23 year old years are probably trying to pay off student debt on a modest salary and an emergency fund is more of a want than a need at that point in their lives.

Like most things personal finance related, there is no size fits all answer. One would believe through that if the choice was between setting up an emergency fund and paying down debt, the priority would be more towards the latter than the former if the level of debt is greater than conventionally believed to be acceptable.

The conventional analysis is to use a debt to income ratio of 28/36;  a household which spends 28% or less of monthly gross income on housing (mortgage, property taxes, condo fees and insurance) is considered to be carrying an acceptable level of debt for housing related costs. A household which spends 36% or less of monthly gross income on debt in general (add housing costs plus credit card carrying costs, student loans, car loans etc.) is considered to be carrying an acceptable level of total debt.

In the great de-leveraging game, a household with debt to income ratios over 28/36 may be better off paying down debt than building or augmenting an emergency fund in order to build some cushion into household cash flow. The other obvious reason is that carrying costs on debt are higher now than interest rates provided in high interest accounts.

In situations where households have acceptable levels of debt, the pay down debt vs. build/augment an emergency fund debate becomes much more a function of personal choice and risk tolerance. I would suggest that households with “lumpy” incomes- such as people who work solely on commission, have fluctuating incomes or work in very cyclical industries may be better off leaning towards building or augmenting emergency funds  since the need to mitigate against cash flow shortages may be more pressing than paying down acceptable levels of debt.

On the flip side, a household that already has 5-6 months of emergency funds on hand may be, from an investing perspective if not from an emotional one, better off either paying down debt or using the funds to invest in products with higher yields than high-interest savings accounts/money market funds. There is an opportunity cost of building an emergency fund with over 6 months of fixed expenses rather than using such funds to invest in something with higher yield. The exception would involve situations such as the primary bread winner of the household being especially vulnerable to economic downturns (either in an industry that does is not recession proof or in a position that would take a long period of time to replace if laid off/terminated).

Building an emergency fund should be a pillar of good household financial planning. However, it needs to be seen in a continuum of competing priorities rather than a dogmatic adherence to building one no matter what the other circumstances of your life are

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