Life is full of uncertainties. You may be having a perfectly fine day, and then all of a sudden, disaster strikes. Whether it’s losing your job or ending up in the hospital, or even a more minor unexpected problem like your car breaking down, these setbacks can be devastating to those who are not prepared. To protect against the financial fallout from these unexpected occurrences, personal finance experts often advise that you should have an emergency fund of three to six months’ worth of expenses saved in the bank. To some, this may seem like a hard pill to swallow, particularly if they have their sights set on growing their money through investing. Is it really worthwhile to have such a large sum of money sitting in a bank account paying almost no interest, or is it actually better to invest that money and figure out how to deal with emergencies if and when they occur? How often do people actually experience financial emergencies, and how much do they really cost? I’ll be answering those questions and more in this article.
What is a financial emergency?
In short, a financial emergency, or financial shock, is a large, unexpected expense. For me, I define a financial emergency as an unexpected expense that costs more than I save in a month. This means that you cannot cover the expense just using your monthly savings and instead have to come up with the money elsewhere.
The Pew Charitable Trusts published a brief about financial shocks and emergency savings in 2015 based on their Survey of American Family Finances, which I will be referring to frequently in this article. I think the survey assessed a fairly comprehensive list of potential financial emergencies, including the following:
- Loss of income – job loss, pay cut, or reduced hours
- Illness or injury requiring a trip to the hospital
- Divorce, separation, or widowing
- Vehicle repair or replacement
- Home or appliance repair or replacement
All of these are large expenses that can occur without warning, necessitating the use of additional funds.
How often do financial emergencies occur?
While you might assume that financial emergencies occur infrequently, perhaps once every couple of years, the Pew survey suggests that they actually occur quite often. In fact, Pew found that 60% of households experienced a financial shock in the past 12 months. This was in 2014, when the U.S. economy was doing quite well, so these results are not due to a financial crisis. This suggests that many families may experience a financial emergency once a year. And these emergencies may even be more common than that. 32% of households reported experiencing two or more financial shocks in a single year. That means half of the households that experienced one shock actually experienced two or more! These are the types of emergencies that families reported facing:
The most common shock reported by respondents was a major car repair, experienced by 30% of households. The second most common was a three-way tie between a major home repair, a trip to the hospital, and a pay cut, each experienced by 24% of families.
How much do financial emergencies typically cost?
According to Pew, the median financial emergency (the most expensive one if there was more than one in a year) cost $2,000 in their survey. However, these costs varied from less than $400 to over $10,000 and increased as household income increased. For families making the median income, which was $53,657 in 2014 and $68,703 in 2019, the median emergency cost $2,500, as you can see in the graphic below. Adjusted for inflation, that would be about $2,800 now in 2021.
How long does it take to pay for a financial emergency?
One way to measure how much of a burden a financial emergency can be is by considering how long it would take a household to pay for it. In terms of days of income, the median financial emergency costs about half a month of income. However, the lower a household’s income, the more days’ worth of income it would take to pay off the cost, even though the cost of an emergency for a lower income household on average was lower. This suggests that financial emergencies are a larger burden for those with lower income, which you might expect.
However, days of income is a poor way to measure a household’s ability to pay for something. Most income goes to paying routine expenses. The portion that could actually be used to pay for an unexpected expense is savings (assuming that a household does not cut back on spending to pay for it), and unfortunately, Americans on average save at very low rates. These graphs from a 2016 paper by Emmanuel Saez and Gabriel Zucman show the average savings rates of Americans by income level:
As you can see, the average savings rate for those in the bottom 90% of household income is pretty minimal. Overall, it is about 3%. However, it has been particularly bad in recent years. From about 1998 to 2010, the average savings rate for the bottom 90% was actually negative. This means that rather than saving money, families were instead going further into debt every year on average. As of 2020, the bottom 90% includes households making up to about $210,000 per year, and in 2014 when the Pew survey was conducted, the bottom 90% included households earning up to about $155,000. This group therefore encompasses most of the income levels queried in the Pew survey. In fact, two thirds of even the highest earning group (making $85,000 or more) are households in the bottom 90%. Calculating a weighted average for this group would give an average savings rate of about 7%, still quite low.
Using these savings rates, we can calculate how long it should take households in each income group to pay for financial emergencies on average. Here is the outcome in terms of months of saving:
|Under $25k||$25k to <$50k||$50k to <$85k||$85k or more|
|25th percentile||13 months||9 months||5 months||2 months|
|Median||34 months||20 months||14 months||5 months|
|75th percentile||105 months||53 months||43 months||12 months|
As you can see, the results are quite large, so here’s the outcome in terms of years of savings:
|Under $25k||$25k to <$50k||$50k to <$85k||$85k or more|
|25th percentile||1.1 years||0.7 years||0.5 years||0.2 years|
|Median||2.8 years||1.6 years||1.2 years||0.4 years|
|75th percentile||8.8 years||4.4 years||3.6 years||1.0 years|
Rather than saying that the median financial emergency costs about half a month of income, I believe it’s more realistic to say that the median financial emergency costs over a year of savings. Indeed, many households struggle for a long time after a financial emergency. Pew found that 55% of households struggled to make ends meet after a financial shock, which Pew defined as a destabilizing shock.
This suggests that the majority of households did not have a sufficient emergency fund to cover the cost of the financial emergency. As you might expect, high income families were less likely to struggle after a financial shock, although 35% of the highest income group still had trouble. These struggles continued for months after the destabilizing shock, as you can see here:
Only 17% of respondents who experienced a destabilizing shock were able to recover within 1 month. On the other hand, at least 37% (and possibly more) were unable to recover for 6 or more months. Even among those with an income of $85,000 or more, 42% of households that experienced a destabilizing shock had not recovered at the time of the Pew survey. Together, this suggests that experiencing a financial emergency when you do not have a sufficient emergency fund available can have long-lasting consequences.
How big of an impact do financial emergencies have on people’s lives?
Clearly, financial emergencies can make life difficult for a long time for households that are unprepared. But how does this manifest itself? Well for starters, households in the Pew survey that experienced financial shocks had lower liquid (easily available) savings than those that did not.
It is possible that households that experienced a financial emergency had lower savings because they used their savings to pay for it, but the survey results cannot say that for sure. It is also a possibility that households with less savings could be more prone to financial emergencies. It is notable that the gap in median savings between the two groups is almost double the median cost of a financial shock, suggesting that paying for the shock is not the only factor at play. Whatever the reason might be, this data suggests that households that experience a shock are less prepared for any future shocks and may have increased difficulties handling another.
Indeed, the Pew study found that households that suffered a financial shock were more likely to experience other financial problems as well, including missing a housing payment or bill, forgoing needed medical care, overdrawing bank accounts, or withdrawing money from retirement accounts.
The percent of households that experienced a financial shortfall in addition to a shock was higher for all income groups, suggesting that this issue is not limited to low income households. It is unclear whether the shortfall occurred before or after the financial emergency, but it is likely that a financial emergency would result in an inability to meet financial obligations. Even if the shortfall did occur first in some cases, it is probable that the subsequent financial emergency would be even more destabilizing.
It is no wonder that a much smaller proportion of households that experienced a financial shock felt financially secure compared to households that did not experience a shock.
Again, we can’t say if the shock group already felt less financially secure to begin with, but if a shock was all it took for a household to no longer feel financially secure, then it was never really financially secure at all.
In summary, the impact of a financial emergency appears to extend far beyond the initial cost. Households that experienced a shock reported lower savings (even taking into account the cost of the shock itself), a higher chance of experiencing additional financial issues, and lower feelings of financial security.
What is an emergency fund and how can it help?
To combat the unexpected expense of a financial emergency, a good strategy is to save up an emergency fund in a FDIC-insured bank account, generally a high interest savings account. This is money put aside specifically to deal with financial emergencies so you do not have to go into debt to pay for them. The money needs to be easily accessible and stable so that it is available when it is needed. This gives peace of mind and can protect against destabilizing shocks.
Wouldn’t it be better to invest the money instead of saving up an emergency fund?
Since an emergency fund sits unused for a large portion of time, you might think it is a better idea to invest the money instead of keeping it in a bank account making barely any interest. Iowa State University professor Charles Hatcher claims this to be the case in his 2000 paper titled “Should Households Establish Emergency Funds?” Hatcher argues that most people would be better served by investing rather than saving up a three month emergency fund, paying for financial emergencies with a credit card. He reasons that this is a better option due to the difference in expected returns between investments (he assumes 6-12% annual returns) and returns on an emergency fund (he assumes 4%) compared to short-term credit card debt (he tests 10-22% interest). These assumptions are generally fine. 12% investment returns are a bit high, but this is offset by the exceedingly generous 4% returns on an emergency fund (this may have been reasonable in 2000, but now you’re lucky to get about 0.50% in a savings account). The average credit card interest rate is currently about 16%, which is still in the tested range. However, other assumptions Hatcher makes are less reasonable and in my opinion make the results of the study questionable.
First, Hatcher assumes that financial emergencies are quite rare. His calculations assume a financial emergency occurs only once every four years or every eight years. This is way more rare than the results of the Pew survey suggest. Rather than experiencing a financial emergency once every so many years, that survey indicated that there is a 60% chance of experiencing a financial emergency in a single year. Hatcher also states that under the most extreme conditions he tested (8% difference in returns and a credit card interest rate of less than 15%), more than one emergency would need to occur each year for having an emergency fund to be an optimal household finance decision, implying that this is very unlikely and thus most households would not need an emergency fund. However, according to the Pew survey, a household has a 32% chance of experiencing two or more emergencies in one year, so this situation is actually not that uncommon.
Second, Hatcher assumes a savings rate of 10% for his calculations. While this seems reasonable at face value, as we discussed earlier, the average savings rate for those in the bottom 90% of household income is actually only around 3%. This makes a huge difference in these calculations. Using Hatcher’s assumption of a 10% savings rate and an emergency costing the entirety of a 3 month emergency fund, it would take 1.5 years to build back up the emergency fund (or pay off a credit card with a 0% APR). With only a 3% savings rate, it would take 5.6 years. Since Hatcher is assuming that an emergency only happens once every 4 years (in one calculation at least), a 10% savings rate gives the households plenty of time to pay off the cost of the emergency and begin investing again. With a 3% savings rate, the households would be hit with a second emergency before paying off the cost of the first. Now, most emergencies don’t cost the entirety of a 3 month emergency fund, but they also often happen more frequently than once every 4 years. Using the median cost of an emergency ($2,500) for a household making the median income ($70,000), it would take 5 months to pay off the emergency with a 10% savings rate and 15 months with a 3% savings rate. Considering that financial emergencies can reasonably occur once or even twice a year, the costs can quickly start ballooning when you can’t pay off the cost of one before being hit with the next. If you’re putting all of this on a credit card with an average 16% APR (and yes, it would be possible to find credit cards with 0% APR for new cardholders at least temporarily), your debt can start compounding and eventually interest payments will overtake your savings.
Third, Hatcher assumes that an emergency does not involve a reduction in pay, so households are able to still cover their monthly expenses while devoting savings to pay off the cost of the emergency. However, as we saw earlier, 24% of households experienced a pay cut in 2014 according to the Pew survey. In this situation, a household without an emergency fund would have to pay for monthly expenses with their credit card and would not be able to pay off that debt in the short-term because of insufficient income. In the case of job loss, the situation would be even worse, and entire months’ worth of expenses would have to be loaded on to a credit card for multiple months (the median unemployment duration as of May 2021 was about five months) with no way to pay it off.
In summary, I believe that it is generally not better to invest the money that would go into an emergency fund. Paying for all emergencies with a credit card is a quick way to amass a lot of debt when emergencies occur more frequently than anticipated, and it can be difficult to get out from under that debt.
Can’t you just pay for emergencies by selling some of your investments?
Sure, that is a possibility. Investments are generally quite liquid, so you can easily sell them to get cash to pay for financial emergencies. However, investments are not stable and have varying degrees of risk. There is a very real possibility that they will lose value at different times. This means that if your investment balance is rather small, there is a chance that it won’t be able to cover the cost of an emergency during a market downturn. Even for those with a large investment balance, I would still recommend against using it to pay for emergencies. It could be fine when the market is up, but it’s not a good idea to take money out when the market is down. Relying on your investments to pay for emergencies can be especially problematic in the case of a recession because unemployment generally increases at the same time that stocks are down. This can lead to a worst case scenario where you lose your job and have to pull money out of your investments during a significant market downturn in order to cover your monthly expenses for an extended period. This is a hard situation to recover from.
How much money should you save in your emergency fund?
This is a good question with no one right answer. The typical recommendation is three to six months’ worth of expenses, and this makes sense to me for a variety of reasons. A three month emergency fund should be sufficient to cover the cost of at least two median financial shocks or one larger 75th percentile shock for most income levels (this is based on the values from the Pew survey). Most people with reasonably secure jobs should be fine with an emergency fund of this size.
However, for people with less secure jobs or in the case of a recession when unemployment becomes more common, it makes more sense to save up six months’ worth of expenses in case of job loss. If you remember from above, the median unemployment duration is about five months, so a six month emergency fund should be sufficient to cover this potential period of unemployment for most job seekers.
When is it okay to reduce the size of your emergency fund?
There are some situations where it should be okay to have a smaller emergency fund. As mentioned above, a three month emergency fund rather than a six month emergency fund should be fine for anyone with a low chance of losing their job. This is especially true if you have a high savings rate. As we discussed earlier, the higher your savings rate, the faster you can pay off the cost of a financial emergency. This means putting the cost on a credit card is a more reasonable option since you can pay it off quickly and thus avoid paying significant interest. Saving more also reduces what you perceive as an emergency. For instance, my wife and I save about $1000 per month on average. When my wife’s car unexpectedly had to have the brakes replaced for $800 a year or two ago, I did not consider that a financial emergency even though it would be labeled as a financial shock in the Pew survey. Instead, it was just an inconvenience. Even with the car maintenance, we still saved about $200 that month. This is what a high savings rate can do for your financial security.
You can also probably get away with a somewhat smaller emergency fund by minimizing potential sources of these financial emergencies. For instance, if you do not own a car or house, you won’t have to worry about unexpected car or home repairs. Similarly, if you have a new car with a warranty or a recently built house in good shape, unexpected expenses involving vehicles or your home are less likely. Also, being in good physical shape can decrease your chance of medical problems. However, make sure to keep in mind that financial emergencies are by definition unexpected. It’s very hard to guarantee that they won’t occur.
Another situation where you wouldn’t need a large emergency fund would be when you have multiple sources of income that can cover your expenses. If you and your spouse both make enough money individually to pay for your monthly expenses, then you would be okay without much of an emergency fund even if one person lost their job. In the same vein, if you have passive income that could cover your monthly expenses, then you don’t have to worry much about job loss.
Financial emergencies can occur at any time and by nature catch us all off guard. Whether a vehicle or home repair, a hospital visit, or the loss of a job, any financial shock can be destabilizing, making it difficult to pay the bills for months and preventing families from being financially secure.
The best defense against these shocks is an emergency fund. This is a sum of money kept in a bank account to be used only in the case of an emergency, basically acting as a shield to protect your finances from the effects of a large unexpected expense. While it may seem frustrating to keep such a large amount of cash in the bank rather than investing it, an emergency fund can prevent worst case scenarios, particularly when multiple financial emergencies occur in a single year.
Most people with a relatively secure job should be sufficiently protected with three months’ worth of expenses in their emergency fund. For those with a less secure job, six months’ worth of expenses is a better option.
While there are situations where you could feasibly get away with having a smaller emergency fund, keep in mind that emergencies are hard to predict, both in frequency and in cost. Having a well-funded emergency fund may mean that you are missing out on potentially greater returns in the stock market, but it can keep you safe from very real and destabilizing losses in real life. The future is uncertain, but an emergency fund is a hedge against this uncertainty and can keep you afloat during tough times.