Get to the answer with these four questions.
Unless you watch reruns of The Apprentice, you probably don’t expect to hear “You’re fired!” anytime soon. Nor might you expect your roof to start leaking, or a water pipe to burst beneath your kitchen floor. But these emergencies happen, and sometimes all at once.
The surest way to manage through a financial challenge is to plan ahead. Commonly, that contingency plan involves having an emergency fund in cash to use when things go sideways. It’s a sensible approach, certainly. You can dip into your safety net to cover your living expenses while you find a new job, or pay for those pricey home repairs. After your situation stabilizes, you can refill the coffers so you’re ready for the next whammy.
Cash savings underperform
That sounds very adult-like and sensible — except for one thing. While you’re waiting for bad stuff to happen, your cash balance is sitting in your high-rate savings account underperforming. In a year when the S&P 500 is up over 25%, it’s tough to accept a measly 2% return on the $10,000 or $20,000 you have stashed away for a rainy day.
The purpose of keeping emergency savings in cash is obvious: You want it to be available when you need it. The market could crash the same day you get fired, after all. And if your emergency fund were invested in the market, you’d have to sell at a loss to make the cash you need available. For many, that’s not a risk worth taking.
But you may have a different outlook. Maybe you could invest your emergency fund and maximize those earnings, without destroying your chances of surviving an unexpected financial challenge?
Here are five questions you can ask yourself to find out. The more times you answer “yes,” the less reliant you are on having that big balance in cash.
1. Is your job stable?
Unexpected loss of income is one of the main challenges an emergency fund is intended to address. But it’s not a risk every worker faces. Your chances of getting fired without severance are low when all of these factors are true:
You work for a large company that must document performance-based firings.
Your performance reviews say you’re rock-solid.
You’re not doing anything shady or intentionally violating company policy.
Your company doesn’t have a history of eliminating jobs at your level.
Consider how these factors apply to your situation. Maybe you’re an office rock star who follows the rules, but you do work for a small company that has historically pushed out older workers. If you have marketable skills, a severance package might be all you need to get by until you find your next opportunity.
You may also be able to rely on unemployment benefits in the short-term. The benefit amount and eligibility requirements vary by state, but generally, you qualify if you’re fired without cause and you meet your state’s minimum time worked requirement. Research the rules in your state and verify that your employer is paying the required unemployment taxes.
2. Could you easily lower your monthly spending?
When your required living expenses are low relative to your income, you have a built-in cushion against financial emergencies. Could you easily cut back on lifestyle and entertainment spending to free up cash? If your job is stable and the answer is yes, you’re less likely to need a fast source of cash.
In the spirit of knowing what kind of risk you’re taking, should you invest your emergency fund, add up your required monthly bills. The total is your baseline living expenses and the amount you need to cover each month if you lose your job.
3. Do you have access to cheap sources of cash?
Even if your emergency fund is invested, your first option when you need cash is to liquidate those investments. But if it’s bad timing to sell some of your portfolio, you could borrow temporarily to bridge the gap. In a pinch, a personal or home equity line of credit could stand in as a cash source. The rates on these are generally much lower than even the best credit cards.
Your cheap source of cash should be large enough to cover your baseline living expenses for a few months. It’s also wise to confirm the deductibles on your auto and home policies. If you do face the perfect storm — losing your job and wrecking your car in the same week — you’ll need cash to cover your deductible as well as your living expenses. Be aware of your health insurance deductible as well, because if you need emergency surgery, your health insurance might not cover costs until you’ve met your annual deductible.
4. Do you have a high tolerance for risk?
Investing your emergency fund is an aggressive strategy. Sure, there’s upside, but a lot could go wrong too. The stress of dealing with a volatile market in the short term, plus the cost of some unexpected catastrophe, might be overwhelming.
In a single year when the market is really strong, the difference between holding $15,000 in cash and investing it might be about $2,000. That assumes a savings-account interest rate of 2% and investment growth of 15%. But you could just as easily lose $2,000 if the market takes a dip. It’s up to you to decide whether or not that risk is worth it.
The middle ground
You could also take the middle ground, by splitting up your emergency fund between cash and investments. And, the money you do invest should go into exchange-traded assets that you can sell on the fly. Exchange-traded funds (ETFs) that invest in large-cap, domestic companies are a good option, because these are diversified and fairly liquid. Don’t invest your emergency fund in real estate, your cousin’s body shop business, or any financial instrument you can’t sell at a moment’s notice.
Experts recommend you keep enough money in your emergency fund to cover three to six months of living expenses. If that’s your goal, try holding, say, two months’ worth in cash and four months’ worth in your brokerage account. Then you’ll have cash, some investments, and cheap debt sources to keep you afloat in case your boss decides to play Donald Trump and tell you: “You’re fired!”
Author: Catherine Brock
Source: Fool: Should You Invest Your Emergency Fund?