Saturday, May 4, 2013

Finally, a REAL emergency fund: Series I savings bonds

I'm incredibly, overly excited about being the proud owner of my very first I Bond. I Bonds are probably my favorite financial instrument. I'm going to use them as the vast majority of my emergency fund, and now I'm going to tell you all about it.

I haven't had a proper emergency fund in years. When I started aggressively paying down my student loan debt in December 2011, I threw all the cash I had at my loans. Before that I don't recall having an explicit emergency fund, just a few thousand dollars in savings, and probably less than that once we bought our house. I've felt bad about it, and I've written about other things that sort of act like an emergency fund without being one, like debt paydown and lines of credit.

But a line of credit isn't a real emergency fund. Neither is a credit card, or relying on a wealthy relative. And everyone needs an emergency fund.

I have a savings account with $1200.66 in it. I want its balance to stay right at $2000. (I'll describe how I calculated this number later on.) Every month I'm transferring $200 into it automatically. But that savings account isn't my real emergency fund. It's just my temporary one.

My real emergency fund is all of my I Bonds. Currently that's just one: a $200 bond that I bought at the end of April. Interest accrues on the first of every month, and I Bonds bought in a month count as being bought on the first of the month — so by buying at the month's end and redeeming at the month's beginning, you're basically getting a month of free interest.

I have an automatic I Bond purchase plan for $200 a month. The bond showed up in my Treasury Direct account on the same day the ACH transfer happened, which is pretty awesome since with every transaction I'm familiar with there's a lag of a few days. The interest rate on that one is 1.76%, which is entirely the inflation component. It sure beats 0.75% on my savings account.

I Bonds can't be redeemed until a year after their purchase date, and if you redeem them before 5 years you lose the last three months of interest. Those are basically the only downsides. Oh, and you can only buy $10k per year (per individual). But that's it, everything else is a positive.

Since any I Bond that I purchase now needs to "cook" for a year until I can redeem it, I can't just dump my temporary emergency fund into I Bonds all at once. That explains why I'm buying a small amount of I Bonds every month. This way I'll build up a pipeline of emergency fund money in I Bonds that will become available over time, so instead of having my savings eaten up by inflation I'll have my purchasing power maintained even across long time horizons.

Eventually I'd like to be buying more than $200/mo of I Bonds. Averaging $833.33/mo will put me at the $10k/yr limit. That's a good goal to shoot for but I doubt I'll have enough assets any time soon to feel comfortable committing that much to pure emergency fund savings. Maybe I'll keep my automatic purchases the same and invest one-off amounts to build my I Bond emergency fund faster.

Okay, wait a second: how did I decide that $2000 is enough for an emergency fund?

Good question! The question of "how much money should I have in my emergency fund?" comes up all the time, especially kicking around personal finance circles on the internet. Most recently I saw this topic broached over at Yay, Goodies. I haven't weighed in on it yet, and that ends today.

The traditional advice about emergency funds is one of: 3-6 months of income, 3-6 months of expenses, 6-12 months of income, or 6-12 months of expenses; I honestly forget which is most common, assuming I ever knew. I think that any one of these is good advice... that is, if you have little knowledge of or little interest in personal finance. As a Level One Mustachian or higher, you can do better than this advice.

The optimal size of your emergency fund depends entirely on your circumstances, and you should decide it for yourself. The most important question is: what will it take for you to sleep easily at night? If you need $50k in a savings account to feel comfortable, and you decide that the money you're leaving on the table is worth your peace of mind; then more power to you, you're doing awesome, and don't listen to anyone who tries to tell you otherwise.

I think it's perfectly reasonable to get by with much less of an emergency fund than conventional wisdom suggests. I'm going to briefly describe the methodology I used to decide on my $2000 emergency fund figure. I'll flesh it out in a future post, since this post is long enough already.

First I made a list of catastrophically awful things that could happen. For me this was: unexpected job loss (for both me and my girlfriend), car accident that would total either one of our vehicles, medical emergency (either acute or chronic), destruction of our primary residence, and a medical emergency involving our pets (two dogs and a cat).

For each of these, I came up with a narrative of the worst (or most expensive) thing that could happen. Job loss is an easy example: if you lose your job, you lose your income. If my car were totaled (maybe if a tree falls on it), I'd have an outstanding car loan, and I'd need an alternate form of transportation.

Then, flesh out the scenario with how you would adapt. If I lost my job, we would cut our expenses as much as possible. Since we have a budget, I can see that trimming $300-400 per month would be easy and automatic (mostly ongoing home improvements and furnishings). Further cuts would probably be possible. Since my girlfriend also works, we would be burning through savings at probably $200-400 per month.

Make a table of these outcomes. I chose to have two columns which I labeled "risky" and "very safe", and came up with dollar figures for each scenario. "Risky" means "what is the minimum possible I would need to barely scrape by?". "Very safe" means "how much would I need to be totally shielded from essentially all risk?".

Once you have the table, you need to decide how to aggregate those values. You can total them up, or pick the biggest value in the "very safe" column, or really whatever aggregation scheme you want. I chose to add together the highest two values, on the theory that losing my job and having a tree fall on my car in the same month is as close to a worst-case scenario as I want to imagine. That gave me values of $2200 in the "risky" column and $5400 in the "very safe" column. From there I basically eye-balled it and decided that $2000 and a $5000 personal line of credit is a big enough safety margin for me.

That's the basics I used to decide on the size of my emergency fund. I'll write it up more completely the next chance I get. As for the emergency fund itself, in two years time I should have my entire emergency fund in readily-accessible I Bonds. Until then I'm stuck with my savings account.