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.