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Emergency fund series: Not in debt

The first two posts in our emergency fund series looked at the possible scenarios when you are in debt:

Emergency fund: in debt, good credit score

Emergency fund: in debt, bad credit score

Today, we look at the management of the emergency fund for people who are not in debt.

 

 

What was the conclusion for people in debt?

We looked at 3 scenarios for people with a good credit score and those with a bad credit score:

1. No emergencies happen during the debt repayment period
2. Minor emergencies occur – two £500 emergencies each year
3. Major emergencies occur – two £500 emergencies each year and one £3400 emergency after 12 months

In each scenario, we investigated the speed of debt repayment based on three methods of maintaining an emergency fund:

1. Standard: where you build an emergency fund of 3 months’ expenses before paying down debt
2. Dave Ramsey: where you build a £600 ($1000) emergency fund before paying down debt
3. Moneystepper: where you use available credit as your emergency fund

 

Based on the three repayment methods for a specific example, we noted the following total amounts of interest paid whilst trying to get out of debt:

 

Good credit score

Method	No emergencies	Minor emergencies	Major emergencies
Standard	£6,140.81	£9,249.23	£15,004.79
Dave Ramsey	£3,718.31	£5,072.02	£8,798.98
Moneystepper	£330.00	£409.32	£1,031.71

Bad credit score

Method	No emergencies	Minor emergencies	Major emergencies
Standard	£6,366.73	£9,831.10	£24,363.66
Dave Ramsey	£3,718.31	£5,072.02	£8,353.78
Moneystepper	£3,290.15	£4,439.19	£7,262.66

Therefore, we concluded that if you have consumer debt of over 4-6% (depending on its nature), you should try to consolidate your existing high interest debt onto a 0% card and use available credit as your emergency fund whilst saving to pay down the borrowed amount before the end of the debt period. If this was not possible, it was still better to use available sources of credit, even if they paid a relatively high interest rate.

For detailed figures and advice, please visit the related posts.

 

A reminder of the definitions and the example

We will be using the same definitions of “debt” as for people in debt in the previous posts:

1. If you have mortgage debt on your own home or on income producing real estate and your interest rate is below 6%, then do not include this in your debt. Given average market returns, you will be mathematically better off by keeping this debt rather than paying it down.
2. If you have student loans with interest rates of below 4-5%, then the same theory apples as per your home mortgage above.

So, this post will be of interest to you if you have no other debt, other than low interest loans (less than 4-5%).

 

People who are not in debt – emergency fund recommendation

In summary, my recommendation for people who are not in debt is the following:

• Keep a credit card open and active with a sufficient credit limit (if you follow moneystepper advice, and can appropriately manage your credit cards, you will be doing this anyway to earn rewards and cashback.
• Try to use a 0% purchases credit card for each emergency purchase. In this scenario, always pay down the credit card before it incurs interest. For our example, we have used the Tesco 19-month 0% purchases card.

 

As in the previous two posts, the advantages of this method are best demonstrated through an example:

“Charlie has no debt (outside of mortgage & low rate student loans). His monthly expenses are £1,200 per month. He has a reasonable credit score and therefore has access to additional borrowings on 0% purchase cards. He has 6 months of expenses already saved today in cash.”.

Charlie has determined that he can put aside £400 each month towards investments and/or maintaining his emergency fund.

 

No emergencies occur during the 30 months – only well budgeted expenses are incurred

1) Standard approach (always have 6 months’ worth of expenses in emergency fund)

In the scenario, Charlie places his cash into a 0% return current account for emergencies. Once this is fully funded, he would place £400 per month into investments returning 10% per annum. He would pay any emergencies off through his emergency fund. He would then use his £400 per month investment to rebuild his emergency fund back up to 6 months’ worth of expenses.

Result: after 10 years, Charlie will have investments of £82,621, and an emergency fund of £7,200 => total cash pot of £89,821.

 

2) Dave Ramsey approach (keep 3-6 months of expenses in an emergency fund)

In this second scenario, Charlie would do the same as scenario 1, but only keep 4.5 months of expenses in his emergency fund. Therefore, at day 1, he would place £1,800 which would have been kept in the emergency fund into investments, and then follow the same pattern as above regarding monthly investments.

Result: after 10 years, Charlie will have investments of £87,493, and an emergency fund of £5,400 => total cash pot of £92,893.

 

3) Moneystepper approach – no cash emergency fund – use 0% purchases credit cards)

Using the moneystepper method, Charlie would put all of his cash savings into investments. He would then put £400 every month into investments. When an emergency occurred, he would pay this on a credit card, but pay off the credit card before it began incurring interest. If the emergency could not be settled via credit cards, he would remove the required amount from his investments to settle the bill for the emergency.

Result: after 10 years, Charlie will have investments of £102,111.

 

Minor emergencies occur during the debt period – £500 emergency twice per year

1) Standard approach (always have 6 months’ worth of expenses in emergency fund)

In the scenario, Charlie places his cash into a 0% return current account for emergencies. Once this is fully funded, he would place £400 per month into investments returning 10% per annum. He would pay any emergencies off through his emergency fund. He would then use his £400 per month investment to rebuild his emergency fund back up to 6 months’ worth of expenses.

Result: after 10 years, Charlie will have investments of £65,891, and an emergency fund of £7,100 => total cash pot of £72,991.

 

2) Dave Ramsey approach (keep 3-6 months of expenses in an emergency fund)

In this second scenario, Charlie would do the same as scenario 1, but only keep 4.5 months of expenses in his emergency fund. Therefore, at day 1, he would place £1,800 which would have been kept in the emergency fund into investments, and then follow the same pattern as above regarding monthly investments.

Result: after 10 years, Charlie will have investments of £70,764, and an emergency fund of £5,300 => total cash pot of £76,064.

 

3) Moneystepper approach – no cash emergency fund – use 0% purchases credit cards)

Using the moneystepper method, Charlie would put all of his cash savings into investments. He would then put £400 every month into investments. When an emergency occurred, he would pay this on a credit card, but pay off the credit card before it began incurring interest. If the emergency could not be settled via credit cards, he would remove the required amount from his investments to settle the bill for the emergency.

Result: after 10 years, Charlie will have investments of £88,941, with credit card debt outstanding of £1,500 => total cash pot of £87,441.

 

Minor and Major emergencies occur during the debt period – £500 emergency twice per year and one £3400 emergency after 12 months (1 year) and again after 72 months (6 years)

1) Standard approach (always have 6 months’ worth of expenses in emergency fund)

In the scenario, Charlie places his cash into a 0% return current account for emergencies. Once this is fully funded, he would place £400 per month into investments returning 10% per annum. He would pay any emergencies off through his emergency fund. He would then use his £400 per month investment to rebuild his emergency fund back up to 6 months’ worth of expenses.

Result: after 10 years, Charlie will have investments of £54,817, and an emergency fund of £7,100 => total cash pot of £61,917.

 

2) Dave Ramsey approach (keep 3-6 months of expenses in an emergency fund)

In this second scenario, Charlie would do the same as scenario 1, but only keep 4.5 months of expenses in his emergency fund. Therefore, at day 1, he would place £1,800 which would have been kept in the emergency fund into investments, and then follow the same pattern as above regarding monthly investments.

Result: after 10 years, Charlie will have investments of £59,690, and an emergency fund of £5,300 => total cash pot of £64,990.

 

3) Moneystepper approach – no cash emergency fund – use 0% purchases credit cards)

Using the moneystepper method, Charlie would put all of his cash savings into investments. He would then put £400 every month into investments. When an emergency occurred, he would pay this on a credit card, but pay off the credit card before it began incurring interest. If the emergency could not be settled via credit cards, he would remove the required amount from his investments to settle the bill for the emergency.

Result: after 10 years, Charlie will have investments of £75,279, with credit card debt outstanding of £1,500 => total cash pot of £73,779.

 

Summary of value of investments depending on emergency fund method

Based on the three repayment methods in our example for Charlie, we have the following total amounts of interest paid whilst trying to get out of debt:

 

Method	No emergencies	Minor emergencies	Major emergencies
Standard	£89 820.81	£72 991.13	£61 917.15
Dave Ramsey	£92 893.48	£76 063.80	£64 989.82
Moneystepper	£102 111.51	£87 441.42	£73 779.22

 

Let’s do a little analysis of this!

In 10 years, depending on the scenario, using the “Moneystepper method” will give you a final cash pot of 15-20% higher than using the “Standard Approach”.

There is no additional “risk” in this approach, as we will discuss below. Most people think that their “emergency fund” is there to save them. However, for the majority of people, whether they are in debt or not, have good credit or not, their emergency fund is actually costing them a fairly considerable amount of money.

I encourage you to do the maths for your own personal situation to determine how much your emergency fund may be costing you.

 

Conclusion – In debt with bad credit rule

If you have no consumer debt of over 4-6%, you should maintain available credit on credit cards to use in the case of an emergency and then pay these down before they begin to incur interest.

 

What about risk?

From the prior posts, one of the most common concerns has been regarding risk. Questions have arisen, as they always do, regarding certain scenarios and worries. Let’s address some of these. If you have any others, please add a comment and I add my response into this section:

 

What if I lose my job?

Fair question. This is certainly an emergency. But, we need to determine how much this will “cost” you. People are worried that they will be out of work for 6 months or more and therefore need a huge emergency fund. My response to that would be:

1. If you lose your employment, you should be able to cut back even more on expenses so that 6 months of “normal” expenses aren’t the same as 6 months of “unemployed” expenses.
2. You are assuming you will be out of work of over 6 months. If you apply yourself and look hard for new work, this should not be the case. As of June 2014, the median length of unemployment was 13.1 weeks, which equates to just over 3 months. Additionally, only 4% of people who become unemployed remain unemployed for over 12 months.
3. You are assuming that when you were made unemployed, you received no benefit. In most cases, a redundancy package or severance pay can form part of your emergency fund in this scenario.
4. This “standard approach” also assumes that you have no income during “unemployment”. This shouldn’t be the case. Pick up some part time work. Mow some lawns. Do someone’s gardening. Deliver some pizzas. There are millions of ways to earn additional income in the short-term.

Given all of these factors, the moneystepper approach should suffice if you have a good credit score. If not, then you may need to liquidate some of your investments. This brings us to our next question:

 

What if it all goes wrong at once?

Another concern people have – people do really like to think of the worst case scenarios – is that you lose your job, the boiler explodes, the house falls down and the markets crash 50% all on the same day.

This is Armageddon. However, if you manage your personal finances appropriately, this shouldn’t be a problem.

Let’s take it one step at a time:

1. You lose your job – see above.
2. The boiler explodes. Annoying. However, maybe not an emergency. A well planned budget should consider household repairs. If you couldn’t afford to replace this when it explodes, then you should have previously taken out insurance. Remember the golden rule of insurance: never insure anything that you can afford to replace. However, if you cannot afford to replace it, you should take out appropriate cover.
3. The house falls down. Again, I’m assuming that you have buildings and contents insurance, or you can otherwise afford to rebuild your house. All planned for already.
4. The markets crash 50%. Alright, I admit it – this might be one of the few instances where certain people may need to change their approach. For example, say I have no debt, but very low net worth. I have exactly £3,000 in the world, and I have invested this in a market tracking ETF. The markets crash 50% and I need £2,500 for expenses. Oh no – we’re in trouble! But, are we really? Firstly, consider the possibility that all these three things combine at the same time. It is very low. Secondly, in this worst case scenario, we have to remove our £1,500 and take out £1,000 on a credit card, which we can get at a low or even 0% rate in the short-term and then we start again. If you take the mean of the returns of this scenario, and the scenario where no emergencies occur, in the long-term you will do much better by following the moneystepper approach.

 

I like having the comfort of seeing that amount sitting in the bank

Grow up!

Only joking…

However, this is a point that I disagree with many. So many times I hear that personal finance is about so much more that maths. Well, as a mathematician, I would have to disagree. That is exactly what it is about. Whether it be savings, retirement, investments, business or anything else, the approach to personal finance – in my opinon – should always be the same:

• Determine the mathematically optimal solution (based or current and historical information)
• Consider the risk (variance) involved with the selected strategy
• Based on this information, adopt the most appropriate strategy for your situation

Nowhere in this formula should we suggest whether we need a “comfort blanket” of seeing a certain figure in a specific bank account set aside just in case aliens invade!

That comfort blanket is sitting there, getting smaller every day and inflation eats it up like a hungry moth!

My comfort comes from knowing that I am making the mathematically optimal decision and effectively implementing it in order to be able to be financially free as soon as possible. My comfort comes from knowing that applying these formulas means that I will be sitting on that beach in the South of France without a care in the world ten or twenty years earlier than I would have been if I always took the “comfortable” route.

 

Emergency funds are a topic of great debate. I would therefore love to hear your comments on this matter. What are your worries about emergency funds? What do you disagree with in my analysis above?

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