What’s the Biggest Newbie Mistake? Investing Without an Emergency Fund

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Financial experts recommend having between three and six months of basic living expenses in an “emergency fund,” whether you’re an individual, business, or real estate investor. You never know when you’ll lose your job or get sick, or when a global pandemic will crash the economy. Relying on government benefits, charities, or family and friends may be necessary, but it’s not ideal. So how much emergency funds do you need? Here’s what to know.

Only 40% of Americans can afford an unexpected $1,000 emergency, according to a Bankrate survey. And a CareerBuilder survey found that 78% live paycheck to paycheck—and this includes 18% of those who earn over $100,000 a year, a report by Willis Towers Watson found.

Small businesses fare even worse when it comes to emergency savings. A 2016 study by JP Morgan Chase found that only “half of all small businesses hold a cash buffer large enough to support 27 days of their typical outflows.” Another disheartening analysis reported in The Street estimates that “approximately 21 percent of all American small businesses will fail within 30 days of being quarantined.” (This is without government relief, of course.)

Large corporations are in the same boat. United and Delta Airlines used an average of 96% of their cash reserves to buy back their own stock instead of saving for a rainy day, a report by Bloomberg found.

Sometimes it’s not even a problem of strategy, though. Many successful investors get the feeling that their cash is “burning a hole in their wallet.” After all, that cash could be earning a return!

Using up that “cash burning a hole in your wallet” so it “earns a return” is the real estate investor’s version of a stock buyback—and we saw how well that decision worked for the airlines.

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What is an emergency fund?

An emergency fund doesn’t have to burn a hole in your wallet if you know what it is and how it can work for you without earning a huge return.

You need to be prepared for any emergency that might require quick money to handle. You can’t predict every emergency before it happens, of course. Still, you can be prepared if you have a catch-all financial emergency plan that equips you to tackle almost any potential emergency that could strike. For all individuals and businesses, this requires cash reserves in an account you can easily access.

For real estate investors, an emergency fund is necessary if your tenants can’t pay or refuse to pay. At the end of the day, someone still has to pay the bank, and that will fall on you.

Why might you need an emergency fund?

Saving cash in a savings or checking account and setting it aside in an emergency fund gives you grace at a time you might otherwise make a desperate decision. If an emergency hits, you could be tempted to dip into your retirement account or other investment accounts to cover the costs. It also adds a safety net so you wouldn’t have to turn to taking out more loans. The emergency fund can protect you now and in the future.

How much should you save for emergencies?

The size of your emergency fund will vary based on your personal risk tolerance, the types of emergencies you’re most likely to encounter, and your personal circumstances (including your income). However, a good rule of thumb is to set aside at least three months’ worth of expenses and preferably six months of expenses or more. You need to know how much you spend in a typical month and plan to cover at least three months to be safe. Your savings goal may be for a greater or smaller number of months, depending on your lifestyle and profession.

What monthly expenses should you include when calculating your minimum emergency fund amount? Make sure to include any mandatory payments, like credit cards, mortgage, rent, or student loans. (Some loans can be deferred in an emergency, but it’s better to be prepared.) Also include things like utilities, groceries, phone bills, and other mandatory monthly expenses. But discretionary spending like going out to eat should be severely reduced in an emergency—so you don’t necessarily need to save enough cash to cover your usual restaurant bill. Remember, your spending habits will change in an emergency, hopefully dramatically so!

It’s also important to estimate your home repairs. Most experts recommend that homeowners save about 1% of their home’s overall worth for estimated home repair and upkeep costs in any given year. For example, if you live in a $250,000 structure, plan to spend about $2,500 in annual repairs. This may increase or decrease depending on your home’s age and condition.

If you can, try to prevent emergencies before they occur. Invest in solid insurance policies that protect you from the bulk of unplanned expenses you’d otherwise face. Take care of your home with upgrades and as-needed repairs. Attend regular medical checkups and keep your vehicle in good running condition.

For investors, the economies-of-scale concept is worth mentioning. With smaller properties with only one or two units, six months of cash reserves per unit is reasonable. But as the property size increases, it’s probably not worth it to have six months saved for each unit. The chances of every unit being vacant or hit by a non-insurance-related emergency at the same time are slim.

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Where should you put your emergency fund?

You should keep your emergency fund in a safe location where you can access it easily. Most mainstream banks are federally insured for up to $250,000 (and sometimes more), making this one of the safest options. However, low risk means lower interest, so don’t expect great returns. Having 2% interest on your emergency fund savings account is great to ensure your cash is instantly available if you should need it.

When should you use the money?

It’s important to only use this money for an emergency you can’t otherwise pay for.

You should be prepared for a variety of financial emergencies, including:

• Vehicular collisions. In an ideal world, after a traffic crash, the party who’s responsible will cover all damages with his or her insurance policy, and you’ll be able to proceed with your life as if nothing happened. You could be the victim of a hit and run—but you could encounter insurance issues or suffer a debilitating injury that prevents you from working. Legal action can help you cover your expenses, but that will take time to resolve—you’ll need to go through the discovery process, strive for a settlement, and possibly proceed to court—and you’ll still need an emergency fund to cover temporary cash shortfalls in the meantime.
• Injuries and illnesses. You can never know when you or a loved one may fall ill and become unable to work. Again, you’ll need an emergency fund to pay expenses not covered by insurance and make up for lost wages in the short term.
• Major home repairs. If your roof starts to leak, you’ll need to fix it as soon as possible. Some home issues could render your house unlivable, and others will only increase in severity the longer you allow them to go unaddressed.
• Natural disasters. Insurance covers many natural disasters, but you may discover certain specific expenses are not included or that your insurance plan doesn’t reference specific disasters.
• Job loss. Even if you’re amazing at your job, you may be laid off or otherwise unable to work. You’ll need to be prepared for that kind of income shortfall as well.

For real estate investors, it’s important to think about these emergencies in each of your units. Repairs, natural disasters, and loss of rental income are all financial emergencies you should be prepared for.

This isn’t to say you should just magically have cash. Holding strong cash reserves should be an integral part of your business plan. It should be something to build toward.

Aim to have approximately 5% to 10% of your assets be in cash or cash equivalents. As your real estate investments grow and your risk is diluted by being spread across more properties, that percentage could fall a bit. Nevertheless, as those financial experts recommend, you should aim to have between three and six months of basic expenses in reserve for yourself and your business.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.