In a world of folks living paycheck to paycheck, a lot of advice is given about how to allocate money before investing, and specifically about having an emergency fund. I’ve always struggled with the concept of an emergency fund, because while I understand the importance of having money available to spend for the things you want to buy, I can’t really think of any emergency in my life that required money to resolve.
If an emergency is a situation that poses an immediate risk to health, life, property, or environment, what role does an emergency fund play in remediating the situation? When someone is choking you don’t throw your wallet at them, and you won’t get very far tossing spare change on an oil spill.
While getting a flat tire while driving may constitute an emergency, paying for a new tire doesn’t. It seems we confuse the term emergency with unexpected or unusual. A washing machine and a refrigerator have a finite lifespan, so even though you might not have been expecting the fridge to break the week of Christmas when you are hosting family members, needing to buy a replacement isn’t an emergency.
And with that frame of mind, I wonder, what’s the point of an emergency fund? Since cash generally isn’t required when firefighters arrive on the scene, or when an ambulance arrives to transport a patient, why tie up money that could be earning a higher return than you get from a savings account?
The conventional wisdom I’ve heard is to save 3 to 6 months of your salary in an emergency fund. That’s kind of crazy. Advice like that makes it clear people aren’t setting money aside for a financial (or other) emergency, but rather for unexpected bills or the inability to pay existing bills (or both).
When we lose a job, we shouldn’t need anywhere near the amount of money we live on normally. While many bills still need to be paid, if you lose an income stream it’s not like you need to continue making retirement investments, go out to eat for dinner, or pay for cable.
If you’ve created a spreadsheet with all of your income and expenses, it should be very easy to find out how much money you absolutely need to live. You shouldn’t create a fund for emergencies, but rather a buffer to cover unexpected expenses, or to cover bills in case you lose your job.
I’m not a fan of having a large sum of money sitting around doing nothing. If you have $5,000 sitting in an account and your fridge dies, that 4 door stainless steel model for $3,000 is going to look a lot more tempting than a $1,000 model that does the same thing. If you have $10,000 sitting around, you might as well consider replacing the stove, microwave, and dishwasher too, since when one thing goes, they all go.
In a true emergency, you probably won’t need money, and if something unexpected happens, most people can fall back on a credit card. Sure, the interest rates are high on credit cards, though most large purchases can be financed at low rates if you don’t have the cash.
Imagine having an emergency fund of $20,000. You have a couple of options on what you can do with this fund. You can invest the money or leave it in a savings account. You can also do both of those options, but when a large unexpected expense pops up, you charge it to a credit card.
We’ll say Person 1 invests the $20,000 in the market, assuming the usual 7% return for 20 years. Person 2 keeps the cash in a savings account at 1%. Over the course of 20 years, each person experiences 4 unexpected events that cause them to need the full $20,000. Two years after the event, they put the money back into the account.
If Person 2 puts the money away in a savings account, after 20 years they’ll have $22,668.53. If Person 1 invests it, they’ll have $56,734.62. You’ll potentially have an extra $34,066.09 by investing the money.
Let’s say now we think a bit differently about an unusual expenses fund, and instead rely on a credit card should something unexpected occur. Now during these 4 crisis, both people don’t touch the money they’ve invested or put into the bank. We’ll assume the cash advance on a credit card has a 3% transaction fee at 18% interest. Where do the two wind up after 20 years?
Person 2 who puts the money away in a savings account, after 20 years they’ll have $24,403.80. Person 1 who invested will have $77,393.69. They also will have paid a total of $18,730.24 in credit card fees. Those fees really add up! If we keep it simple and pay the fees from the emergency fund, the actual difference is $3,988.93 for the savings account guy (Person 2), and $41,676.31 for Person 1, the market investor.
What does this mean for you? There might not be any right answer, but don’t just base your choice on emotions. You might never have any unexpected expenses; so not investing the money would cost you tens of thousands of dollars.
A good reason I’ve heard for not investing an emergency fund is the market may down when you go to withdraw it. You have a 50:50 chance of having less money in your account when you withdraw it versus when you deposited it, but realize in general markets go up.
Perhaps a hybrid strategy makes sense, invest the money you would spend on unexpected expenses, and when you need the money, if the market is up, withdraw it from your investment account to pay for the expense, and if the market is down, put the expense on a credit card.
What else should you consider? Do you have more than one income? Would it be difficult for you to find another job? Do you have your expenses under control? Do you have a credit card with a high enough limit to cover large unexpected expenses?
Of course, all of this advice assumes you’ve paid off all high-interest debt and are already contributing a substantial amount of money towards your retirement. If you haven’t done that yet, then perhaps you have a real emergency after all.