The following is a guest post from Ian Nuttall. Please post any questions or comments below. If you’re interested in doing a guest post, please contact me with the subject line “Guest Post.”
One of the most common pieces of financial advice involves the much-lauded emergency fund. Chances are, at one point in your financial life, you’ve heard all about why an emergency fund is necessary and what will happen if you don’t have one.
However, you might be surprised to hear that having an emergency stash isn’t necessarily the right way to go and might be costing you more than you think, especially if you have debts. You’re worth more to a bank with debt.
The “problem” with emergency funds
A chief problem with the emergency fund is the concept of “emergency” itself. Emergency is tied to necessity, but the line between what we need and can live without is often blurred. For example, a broken dishwasher may constitute an emergency to some people but not to others.
The recommended amount of money you need for an emergency fund may easily eclipse your available income or balloon to a high amount because of the fluid definition for emergency.
Financial advisors often recommend your emergency fund total enough to cover anywhere from three to six months’ worth of expenses. For many people, the recommended emergency fund amount is more than $2,000.
Now, we have a possibly bloated emergency fund that’s essentially sitting around until an emergency occurs. The money isn’t doing anything substantial for you with regard to a return. Even if you’ve got it in a savings account, the historically low interest rates won’t give you a serious yield on your money.
Emergency fund math (without the boring!)
If you keep an emergency fund of $2,000 in a savings account with a three percent interest rate for a year (after tax), you’ll earn something like $50 total. If you manage to keep the money in your fund for the for two years, you will just about break $100 in total interest.
While you’ve got money stashed away that isn’t working for you, you’ve also got debts. Those debts charge you interest at a much higher rate. Debt interest rates vary widely, but it’s not uncommon for a credit card to have an interest rate over 15 percent. The money you’ve got squirreled away in your emergency fund could have gone towards your debt, saving you quite a bit of money in interest in the long run.
Say you’ve got a $2,000 balance on a card with a 15 percent interest rate. You’ll pay approximately $300 in interest if you don’t manage to pay the card off early. At the same time, that $2,000 sitting in your emergency fund only netted you $100. By keeping that money in your fund, instead of using it to pay off your card, you cost yourself a total of $200.
The above example illustrates why banks and financial institutions often push the idea of saving and savings products on consumers. In most cases, banks make more money off you if you save or stash away funds instead of paying off debt first. The bank paying you $50 in interest might be the same institution making $250 off your credit card.
And that’s just an example. The average credit card debt per household right now is closer to $16,000 so you can do the math on how much interest that adds up to over the lifetime of your repayments.
But what if there “is” an emergency?
Now, you might be worried about the consequences of giving up your fund. What will you do if an emergency happens? A possible option is for you to use your paid-off credit card to cover the unexpected costs, which won’t leave you any better or worse off than before. You don’t have to close your credit card account after you’ve paid the card off.
In fact, you should have credit available in case you need it. There’s simply no guarantee an emergency will happen, but your credit card company will definitely charge you that interest.
Do you have an opinion on emergency funds? Do you agree or disagree? Let me know in the comments!
About the author
Ian Nuttall is the online editor of Debt Help Scotland – a leading debt advice portal for residents in Scotland. He enjoys helping other people to save and make money, investing, and spending time with his family.
January 17, 2013 at 6:08 pm
This is an excellent post.
An emergency fund is just like self insuring the risk of something unexpected. The only problem? Your paying for it upfront, and it comes at a huge capital cost in terms of lost potential investment income. Depending on if any when you have an emergency, you may take advantage of it, but who knows when and if that may occur.
Its one of the reasons i’m thankful for having passive dividend income that I can lean on in the event I really need on should something like that arise, and not have to tie up $20k in capital for an event that may or may not happen.
January 20, 2013 at 8:24 am
I agree, ultimately an “Emergency Fund” depends on individuals situation. Some individuals who don’t have consistent work history should have a more substantial emergency fund vs someone who has worked at the same company for decades.
Additionally like you previously mentioned the recommended 6 months of living expenses is a substantial amount of capital that could be earning a decent return and not be subject to inflation over the years.
January 17, 2013 at 6:35 pm
While carrying debt I agree, a full 6-months emergency fund is going to waste because most of the time you’re getting charged much more in interest on that debt, especially with the low interest rates. However once all the debt is gone I don’t see a reason why you shouldn’t have at least a little bit of an emergency fund. I know my credit would most likely still be available but I’d rather not immediately start racking up debt in the event of a job loss because that will put you even further behind. Just my 2cents.
January 20, 2013 at 8:30 am
Other than $500-$1000 in a savings account for emergencies we do not keep a robust emergency fund, granted my family’s situation might differ from others. I have used credit cards in emergencies but always pay them off in full.
January 17, 2013 at 6:54 pm
While I agree with you that you can use a credit card to cover expenses for a while, having a cash emergency fund does make sense, because there are bills you can’t pay with a credit card – such as a mortgage.
January 18, 2013 at 9:52 am
Just an FYI, there are ways to pay a mortgage with a credit card, they just usually have high fess or lots of hoops to jump through that make it not worth doing.
But in general your point is correct, having a cash reserve to pay certain bills is a very good thing.
January 20, 2013 at 8:44 am
We use our credit cards via our bluebird account to pay our mortgage. We LOVE cashing in on all these reward points that we use to lose by paying our mortgage from our bank acount.
January 20, 2013 at 8:45 am
And yes. Having cash on hand to pay your mortgage in case of an emergency is NEVER a bad thing.
January 25, 2013 at 8:16 am
What’s a bluebird acct? Never heard of it before. Sounds like it may be something we want to check out. Thx
January 17, 2013 at 9:39 pm
I disagree with the idea of using credit card as emergency fund. That can easily get you deep into debt. I have a few savings accounts, each has its own purpose. I use them for very short term saving, usually savings for a purpose. For example I am a member of ASHRAE and every year pay 190 dues. So I save $16 monthly to a dedicated savings account and when the dues arrive, I use a credit card, but when the bill from the bank arrives I withdraw the savings account and pay the CC off. I also have an emergency account if something happens such as my car breaks (and I need it), something in the households breaks and it is needed, i.e. plumbing stuff, etc. For a job loss emergency I agree it doesn’t make sense using a savings account and I invest my emergency fund, but that is for the case of a loss of a job.
January 20, 2013 at 8:56 am
A credit card as your only source of funds during an emergency is indeed putting all your eggs in one basket.
January 18, 2013 at 12:36 am
I’ve always gone with Dave Ramsey’s suggestion of having at least $1,000 in your emergency fund before you start to pay off debt. I can see your point from a financial perspective; however, I think most people feel better, from an emotional perspective, if they have some money in an emergency fund.
January 20, 2013 at 8:58 am
I like Dave Ramsey and agree with a couple of his principles. Having a modest amount in an emergency fund based on your situation is ok, but if you have debt your main goal is to pay it off quickly.
January 18, 2013 at 10:57 am
I would tend to disagree about not needing an emergency fund, even if you have debt. In fact, I think it’s even more necessary then as you’re more likely to revert to using the cards in the event an emergency comes up. Having $1000 or even $500 in savings will go a long way to cover many things that might occur.
January 20, 2013 at 8:59 am
Having $500-$1000 in savings is never a bad thing. Debt on the other hand it unacceptable =)
January 18, 2013 at 1:32 pm
I wrote a post a few weeks ago about how we might have some redundancy in our emergency fund, simply because we have savings earmarked already for other purposes that would likely get put on hold in the event of a true emergency, making that money available should something big and unexpected happen.
January 20, 2013 at 9:01 am
You articulated what I was thinking perfectly! Not all emergency funds are bad but a lot of them that I have seen have redundancy and is not necessary in order to have a decent financial cushion.
January 18, 2013 at 1:48 pm
Emergency funds are an iffy subject for me. If you are buried in high interest debt, financially it is more practical to get that puppy paid off. The wealthy liquidate some of their assets to cover unexpected expenses; ideally, this is a good position to strive for. For those of us in that ‘in between’ wealth-building phase, however, emergency fund reserves might help prevent total wipe-out.
January 20, 2013 at 9:03 am
Jennifer you make a great point. While my family and I are blessed it is imperative to remember that everyone’s situation is different. In the event that we had an emergency we would certainly liquidate assets while others may need to rely on an emergency fund they had stashed away.
January 19, 2013 at 3:06 pm
This is an interesting topic. I currently keep about 2 months pay in a savings account for emergencies. Since I’m in the military my job is guaranteed (but I can’t quit either) meaning losing job income is not a concern. I used to keep about 3 months pay, but decided to reduce it at the end of 2011. I honestly haven’t thought about this is in a long time, but it might make sense to reduce it again. The money is truly just sitting there collecting dust. The last I looked my savings account paid .11%! Ouch!
I wouldn’t be comfortable having less than $1,000 in case of car repairs or something worse. The sleeping well at night factor cannot be underestimated.
January 20, 2013 at 9:05 am
When I was in the military I didn’t have an emergency fund at all for the reason you stated above. I knew I was getting paid next month and our housing + meals were paid for. Obviously not everyone has the luxury of this situation and that is why I make it clear that everyone’s situation is different.
I would say $1000 is the perfect amount for a cushion and investing the rest in Dividend Kings couldn’t hurt!
January 21, 2013 at 12:09 pm
Marvin, I love your blog, but this guest post drives me nuts….especially lines like this:
“If you keep an emergency fund of $2,000 in a savings account with a three percent interest rate for a year (after tax), you’ll earn something like $50 total. If you manage to keep the money in your fund for the for two years, you will just about break $100 in total interest.”
Emergency funds aren’t about math. They’re about a foundation on your financial house. Because you have an emergency fund you can jack up the risk you take on your investment portfolio without risk you’ll have to dip in.
If we want math about the emergency fund, it’s this equation: emergency fund + investments = not totally hosed when the market’s down and you have a need for cash.
January 21, 2013 at 2:42 pm
Thanks for the feedback!
I agree that an emergency fund is ideal in certain situations, however I personally find holding 6 months in expenses (over $15k) unnecessary.
January 21, 2013 at 2:45 pm
But I think that depends on your job prospects, right? If you’re someone in a field where it’s difficult to find work, it stands to reason you should have more in your fund. Also, if you’re out of work, it’s difficult to use your credit card as a reserve. Where is the money coming from to pay it?
Good stuff. I love all the comments on this post. Great discussions!
January 21, 2013 at 8:50 pm
Correct, definitely depends on ones situation. When I was in the military it made no sense for me to have a hefty emergency fund because I knew I was 99.99999% guaranteed my paycheck next month.
Thanks for adding to the discussion I enjoyed reading all the views on emergency funds. I think it goes to show that everyone’s individual circumstance is a little different.
January 21, 2013 at 4:18 pm
Nice post. Personally, I like to keep about $2,000 in a true cash emergency fund. The rest of my “cash” I’m comfortable investing in the market. I’m okay with the risk that obviously that money could lose value. As for that money not being truly liquid, well it takes at most a couple of days to sell the stocks, cash out, and transfer. So that’s not a worry for me.
But yes — if you have credit card debt, that should be taken care of first.
January 21, 2013 at 8:53 pm
Thanks for the input Mike! I don’t consider my stocks true liquid either, like you I can get to the money within 3-4 business days.
January 31, 2013 at 4:31 am
It’s not so much the financial benefits of having an ER fund (altho those are significant), it’s much more about the psychological benefits. For the life of me I could not get spouse to buy into the need for an ER fund – so I just did it – without spouse’s knowledge. Since then we’ve had what I consider 3 very significant ER’s and when we were able to pay for all of those with cash – wow did spouse ever become a believer. I think I may have created a monster – ha! A nice monster, but a monster nonetheless.
January 31, 2013 at 9:19 am
While I never advocate doing something behind your spouse’s back I am a big believer in results! It sounds to me like you obtained the desired result and it has helped you and your family on numerous occasions. I’m glad you were able to create a monster =)
My wife is the same way she’s very up to speed on personal finances but stops there. I try to encourage her to get into investing but she shows no interest, she could be a far better investor than me in my opinion. I know her drive, dedication, and intellect but for the life of me I cannot get her interested in financial statements! Maybe one of these days I will get to create a monster of my own