Does an Emergency Fund serve you well or give you the illusion of security?
There seems to be a generally-accepted rule that having an emergency fund is wise and that the correct amount to hold is somewhere in the range of three to six months worth of expenses. Some advisors insist that a dollar figure, such as $5,000, is the way to go, but the bottom line is that an emergency fund of some kind is thought to be valuable. And by emergency fund, they mean a pot of easily-accessible cash to cover unexpected expenses such as the car breaking down, the furnace calling it quits, losing your job, or incurring health-related expenses. Pretty much any larger expense that might cause financial pain in any given month gets lumped into this category.
Let’s back up a bit. Is an emergency fund a good thing? Under what circumstances? Can you get by happily without one? And what constitutes an emergency?
Every time I’m faced with decisions regarding finances, I go back to a couple key questions. First, are the underlying assumptions behind a recommendation correct? And second, what is the highest, best use of my cash? Let’s apply these questions to the notion of emergency funds.
Is that really an emergency?
Let’s say you need to buy a new car because yours is on its last legs, and you come into my Excellent Car Dealership to chat about one of my offerings. What would you say if I asserted that the beauty in front of you will never need repairs? Never going to face worn-out brake pads, or a snapped timing belt, or issues with the starter. How about that?
Yeah, that’s what I thought you’d tell me. Pure fantasy, right? Because cars break down. It’s what they do, eventually. They all need repairs to varying degrees. Someone I know got two lemons in a row: two new cars, two seized transmissions. Can you believe it?
The point is, mechanical things break down, typically at inconvenient times. So why, then, do we not expect it and plan for it when we buy things that break down?
Want to know what else breaks down? Stoves, as in my stove on Christmas Eve when my then-boyfriend’s parents were over for a meal (we used my “baked” buns as hockey pucks afterwards – not kidding), or the furnace on one of the coldest days of the year (you can read about that story in my book).
These moments are annoying and frustrating as all get-out, and they might also be urgent, like the furnace story on a freezing January day. Nonetheless, I would argue that these sorts of failures are to be expected. They are not emergencies.
Getting a nasty diagnosis, being hit by a bus, losing a job – those are true emergencies; the sorts of events that blindside you and can send you for a financial loop.
So what? Isn’t it all just semantics?
The way we frame a situation drives our actions.
What if, when we work out the affordability for something we want to buy that will require repairs or maintenance, we also factor in a monthly savings portion to cover said maintenance and repairs over time? How would that change our experience?
For example, when you buy a car, you could budget $50-$75 per month, set aside in a high interest savings account called Planned Expenses Account, for the eventual repairs. Three years later, when you go to a mechanic to have the oil changed and he informs you that all your fluids needs to be flushed for a total cost of $1,200 (been there, experienced that), you won’t be pleased, but it won’t cause you financial stress either since the funds are waiting for you in the Planned Expenses account. You’re prepared for this hiccup.
What if you can’t afford the savings portion? Then I would argue that you probably can’t afford the item. I spent ten years watching people with consumer debt and the bare minimum for a deposit rush into home ownership. It didn’t end well. They would have been better served to spend more time dealing with their debt, then accruing savings, before going down the path of ownership.
Back to the Planned Expenses account: The amount you need can’t be prescribed, because it depends entirely on how many things you own that can break down. If you’re a renter, not a homeowner, then you don’t need to worry about the fact that the recent wind storm tore a heap of shingles off your roof. The landlord is the one who should have upped his/her Planned Expenses account.
What About Emergency Funds?
Assuming that you have all of your protective insurances in place (i.e. life, disability, and critical illness), the question remains: How much should you set aside to cover your living expenses in the event that something unforeseen knocks you off kilter and packs a financial punch? Do you really need an emergency fund for those moments?
My husband and I do not have a personal Emergency Fund. We keep six months of operating funds in our corporation for the business “what ifs”, but on the personal side, we keep a line of credit with a large credit limit. We don’t use it for anything other than emergencies, and thankfully, we have not had one to date that we couldn’t handle with our existing monthly cash flow. We set ourselves up this way because we prefer to optimize for returns on our extra cash. In other words, we would rather invest our extra money to garner higher returns than have those funds sitting in a high interest savings account earning 2.3% – the best rate on the market at the time of writing. If worse came to absolutely worst, we could liquidate some of our investments, though that would be the very last step.
This approach works for us because we have no consumer debt, no personal mortgage, and strong business income. In other circumstances, having an Emergency Fund would be a great idea.
Here is a chart outlining the process to determine when to create an Emergency Fund:
Why tackle debt first?
One of the objections to tackling corrosive consumer debt before starting an Emergency Fund is that it can be discouraging and stressful not to have any savings set aside. The people who raise this objection insist that it’s better to start putting an Emergency Fund in place while working on your debt. That way, you have funds to cover smaller emergencies when they arise and you don’t always have to use credit cards or lines of credit.
I get that we are psychological beings and that it’s comforting to have some savings in place. However, this approach makes no mathematical sense. If your goal is to get rid of debt and build an emergency fund as quickly as possible, then the best way to achieve that is by tackling debt that costs between 18% and 25%, instead of parking some of your funds in accounts that will pay you a pittance in interest.
After working with dozens of couples who were mired in a cycle of credit card debt for years, I would argue that spending behaviours that fuel credit card balances are more discouraging than not having a few dollars saved.
Taking an honest look at your spending patterns and finding ways to live on much less than you earn will yield far greater results
than giving yourself the illusion of security by placing funds in a savings account while carrying credit card debt.
Let’s use a concrete example to demonstrate. Let’s say that you’ve just received a tax refund of $2,000. You have a choice to make: you can either pay off $2,000 of credit card debt or place the funds in a high interest savings account (HISA) to serve as an emergency fund. What would each choice yield? Let’s assume that the HISA pays 2.3%, which is the best rate you can find at the moment, and that the credit card interest rate is 19%. We further assume that you will make $100 monthly credit card payments. Here’s how it would look.
You create an Emergency Fund with the $2,000:
Interest costs on your $2,000 credit card debt using this calculator:
What this demonstrates is that by choosing to create an Emergency Fund with the $2,000 instead of paying off the credit card debt, you will gain less than $100 in your savings account while paying more than four times that amount in interest costs over a two-year period.
If, after all this, you still argue that it’s better for you to build a small emergency fund while tackling your credit card debt, then so be it. Some movement forward financially is better than no movement at all.
Opportunity cost and peace of mind
Let’s say you’ve paid off your consumer debt and you’ve created a Planned Expenses Account. What do you do with the remaining cash flow? Is it better to use a chunk of those funds to create an emergency fund in a high interest savings account, thereby sacrificing returns on your money (opportunity cost)? Or invest the funds for a greater yield, knowing that you will either need to use borrowed funds or sell off assets in the event of an emergency?
The answer depends on your personality. If you have limited cash flow or the idea of not having that financial safety net stresses you out, then having an emergency fund is the right step for you. If, however, you’re in a solid place financially, you’re fine with the idea of using a Line of Credit to float you through a tough time, and you’d rather make your cash work for higher returns, then you don’t need an emergency fund. Perhaps you have a foot in both worlds: you like high returns, but the sight of a healthy emergency fund makes you feel much better. If so, then a hybrid approach makes sense.
The Delphic maxim “Know Thyself” applies here.
Whatever you decide, set yourself up to minimize the financial impact of an emergency. You’ll have enough to deal with if/when life happens without having to stress about money as well.