You may have asked yourself this question at some point, even prior to encountering this blog: “Am I ready to invest?”
On the surface, it seems like a question that would have a fairly simple answer: “Of course I’m ready to invest? Why wouldn’t I be?”
After all, if you’ve read along on this blog so far:
That’s great, and you’re on the right track already. But you still may not be quite ready to invest yet. One reason that could be the case is because you might be in a position in which, were you to invest, you would have to dip into your invested money in order to cover an emergency.
That’s something you definitely do not want to have to do. You need an emergency fund. In fact, it’s essential you have one. Just how essential?
If you don’t already have one, you need to build an emergency fund as soon as possible. Without one, it will be very difficult to get anywhere in investing.
“Emergency fund?” you say. “But I’m a pastor and we’re a single-income family!” “But I’m a seminary student and barely have enough to get by after my tuition’s paid!” “But I work for a ministry organization that pays me much less than what I could be making doing a similar job elsewhere!” Believe me, I understand.
I am not at all saying that building an emergency fund is easy. But I am saying it’s essential for investing. And I wouldn’t be helping you by pretending that it isn’t.
Now let’s break down why having an emergency fund is essential to investing.
The purpose of an emergency fund is exactly for what it is named: emergencies. You know how some unexpected significant expense always seems to pop up at the absolute worst possible time? You’ve been there, right? I certainly have.
Granted, there’s no good time for an emergency expense. But it seems as though they always hit when it really, really hurts.
The washing machine goes out right after you’ve been told some of your hours at work are being cut. Your A/C unit goes out right after you paid an unexpected medical bill. Your car breaks down the same week your tuition payment is due. Your kid jumps off the couch, thinking he’s Superman, and breaks his arm on Saturday morning, and the deacons tell you in a meeting on Sunday night that your salary is being cut because giving is down. You get the idea.
Understanding what an emergency fund does and what it covers is fairly straightforward. We’re talking about an unexpected expense that your normal budget can’t cover. But the specific relationship between an emergency fund and investing may not appear obvious at first.
We all understand that when we are faced with a financial emergency of some sort like those mentioned above, even something as “small” as an appliance repair, the funds for the emergency must come from somewhere.
For many of us–and all too often–such emergencies are not funded by ready cash on hand in our checking/debit accounts (because those funds have to go to regular known expenses like utility bills, food, rent, mortgage, etc.), nor are they funded by cash in savings (because there often isn’t any cash saved, if we’re being honest).
In such scenarios, our go-to is often to fund emergencies with our credit cards because there simply is no other option. We pay with the credit card and hope that we will be able to pay off the emergency expense within a reasonable amount of time, whatever we determine that to be.
Often, we fail to do so and end up adding to a credit card balance we carry month-to-month, paying an extremely high interest rate (I’ll be addressing the problem with credit cards in a later post). The other alternative–if we don’t have cash on hand, we don’t have cash saved, and we don’t want to use credit cards–is to tap into our investments (including any retirement accounts, if applicable) to cover emergencies, which is precisely what we do not need to do. Why not?
Because every time we do so, we are negatively impacting the ability of our investments to that point to compound in the future. Here’s a brief example, using compounding interest (compounding interest will be covered in more depth on the blog later).
Let’s say that I have a $10,000 balance in my investment account (and for the sake of simplicity in this example, I’m never going to make another contribution to it ever again). And let’s say that I can expect to earn a 6% annual return on my investments for the next 40 years.
At the end of 40 years, I would have $102,857.18.
But now let’s say I had an immediate $2,000 medical emergency that insurance wouldn’t cover, and I pulled it from my investment account, bringing my $10,000 down to $8,000. Now I have only $8,000 to compound over 40 years.
At the end of 40 years, I would have $82,285.74 rather than $102,857.18. A difference of $20,571.44. That’s huge.
But what if the emergency was job loss, and in the intervening period between jobs, I actually had to pull $6,000 from my investment account to supplement my unemployment monies, thus cutting my investment account down to $4,000?
In that instance, we’re talking the difference between $102,857.18 and $41,142.87 at the end of 40 years, a whopping $61,714.31 less in what I would have had. Ouch.
So when applied to investing, this is exactly why we want to build an emergency fund to cover unanticipated expenses as they occur. Tapping into our investment accounts (typically our retirement accounts) to fund such emergencies simply does too much damage to our future financial well-being.
Think of it like this: You can’t afford to pull money from your investments when faced with a financial emergency.
So how, then, do you build an emergency fund when your budget is stretched so thinly that there is no money that isn’t already being used to cover normal expenses? There are no easy answers here.
All I know to say is that you do whatever you have to do in order to build the fund to its initial target amount. Perhaps you cancel a streaming video service and funnel that monthly fee into an emergency fund. Perhaps you eat out fewer times per month until you reach it. Perhaps you forgo some other discretionary expense for a temporary period. There are any number of possibilities you might consider.
The bottom line is that you do whatever it takes to build an emergency fund to an initial target because you want to avoid at all costs having to pull from any money you have invested. An emergency fund is that important.
Therefore, if you’ve never invested yet, you build an emergency fund to an initial target before you begin investing. If you’re already investing through your employer’s retirement plan and there is no matching contribution from your employer in the plan (I’ll cover this later on the blog as well), you cease retirement plan contributions until you build the emergency fund to an initial target.
If you’re already investing through your employer’s retirement plan, and there is a matching contribution from your employer, you contribute just enough to receive the maximum match, and then funnel any of your own contribution above that into building your emergency fund to its initial target.
So what’s an appropriate initial target for your emergency fund? Next time.