To Emergency Fund or not to Emergency Fund?

Posted by admin on October 4, 2007 in Investment Advice

The funny thing about starting and running your own small business is that you have to become a magician. There’s a lot of smoke and mirrors involved in making sure you look bigger than you do and you are not merely a one man shop. In a previous life, I started a small business approximately 4 years ago with basically a lot of guts (or insanity- take your pick), lots of smoke and mirrors and not that much starting capital. My office was a sublet in the sub-basement of an office, I actually did a lot of my own deliveries at lunch to save money on courier fees and my computer was the one I used in grad school with a bunch of new parts put on by my brother. In other words, the business was being run on financial smoke and mirrors- allocate money where you need it and no where else and prey nothing bad happens (I never did tell my landlord I had no tenant’s insurance even though I was supposed to)! I once had a heart attack when my $800 printer broke after 3 weeks of use before I realized that it was still on warranty- the first thought that came to mind was I could either replace the printer or cut my own pay that month.

This experience probably influences me on why I am so pro emergency fund. Financial Blogger wrote on the flip side of this argument on why there is no need for an emergency fund. I don’t believe the argument is fundamentally wrong. It really comes down to what life experiences you have that influence your thinking on emergency funds or personal finance in general. When I was a kid I couldn’t understand why my Dad, who also ran his own business, kept a lot of money around in his business- why not pay yourself more or spend it? When you end up being self-employed, the word “emergency” means a lot more than disability, emergency car repairs etc.- it means the printer breaking, an ex-employee stealing your entire hard-drive and having to pay to recreate your records (happened to a friend of a friend), spending hundreds of dollars for printing costs for a last minute pitch you have to make, your client not paying you for 45 days- stuff just comes up (do you want to know why employers freak out about stolen stationary? Stationary bills are staggering once you have to pay for it yourself!).

When the stuff comes up you are either drawn down on your line of credit and you don’t want to draw down anymore (or can’t) or you need to have cash around; I now understand my Dad’s strategy about keeping cash in the business. These are the types of experience I have which influence my thinking. I have friends who have secure pensioned jobs who also psychologically need to know they have an emergency fund around. Debt just makes them (and me) uncomfortable given our experience, upbringing and environment.

Moving away from the psychological side of things, if you do not have extended disability or critical illness coverage, not having an emergency fund also means you are relying on the fact you have a line of credit which you have not drawn down on substantially, interest rates stay low and you can return to income producing activities in a short period of time to pay off the line. A lot of things have to go right in order for that to occur. In many ways, we have so little control over our investments (stocks go down due to events far away, pipes burst in your investment property, bonds cannot be cashed because of no institution will accept them for now) being in cash is one of the few things I can control. Yes, its very old-fashioned but many old-fashioned people have become millionaires by buying IBM 30 years ago and never selling.

An opportunity cost argument is also made about not keeping emergency funds- why keep one around if you could invest those funds? I started building up an emergency fund about 2 years ago once the business’ cash flow smoothed out a little and the one thing I noticed is that it also disciplined me to save more money for non-emergency reasons- I knew a part of it was tied up for the emergency fund so I needed to save more money so I could invest it. I may now contradict myself a little here but the thing about an emergency fund is that if you are over-funded there is nothing stopping you from using a part of that to acquire assets when they are cheap (come on market correction!). But over-funding an emergency fund keeping in mind this fact helps you put money aside rather than spend it. The opportunity cost argument only works if you have the discipline to actually utilize funds in income producing activities. If you do then more power to you.

I don’t believe there is a right or wrong to whether you should have an emergency fund or not. It comes down to risk tolerance, life-experience and comfort level.

Are people building emergency funds or are people using their LOC as a buffer? Let me know your thoughts.

6 Comments on To Emergency Fund or not to Emergency Fund?

By MillionDollarJourney.com on October 4, 2007 at 9:05 am

Great post, if you don’t mind me asking, what kind of business do you run? I can see how the emergency fund philosophy would differ for someone who has irregular income.

By Riscario Insider on October 4, 2007 at 9:57 pm

Emergency fund vs line of credit? Having both gives additional flexibility. I’d worry that the line of credit would not be available at the time of the emergency.

MillionDollarJourney makes an interesting point. With a fairly stable income, a line of credit seems sufficient. The money that would otherwise be in your emergency fund could then be invested in higher yielding, less liquid investments.

I’m glad you figured out that your printer was still under warranty. No one wants a big shock just after a purchase. Imagine if you’d bought used.

By admin on October 5, 2007 at 11:56 am

I use to run a business advisory service. The costs were reasonable but the cash flow as unpredictable. You never knew when your clients needed you.

Riscario: Printers are almost loss leaders for the printer companies now so I am not surprised that they don’t put too much craftsmenship in it.

By Reasons Why Your HELOC Can Be Your Emergency Fund on February 26, 2008 at 6:07 am

[...] Dollar Journey says he relies on a line of credit in an emergency. Never one to follow a crowd, Thicken My Wallet likes the cash method for emergencies – the more the [...]

By squawkfox on February 26, 2008 at 4:38 pm

I keep an emergency fund. Since I don’t own a house…

By Nine Lessons Relearned from the Financial Meltdown | Canadian Capitalist on September 20, 2009 at 9:35 pm

[...] Keep an emergency fund. For me, this is the most important lesson of the financial crisis. I had believed earlier that a line of credit can serve as an emergency fund but not anymore. Though it never actually came to that, this crisis has amply demonstrated that a line of credit could be cut back or even become unavailable in a serious financial crisis — precisely when we may need a credit line the most. Now, I think a stash of cash that will cover three to six months of expenses is absolutely essential, despite the…. [...]