You have probably heard of “emergency fund” before in relation to financial planning. It is a common advice advocated by many financial services that some amount of money should be set aside, so that if there is an emergency, such as losing income, unexpected medical bills etc., you can pull it in to save the day. It is widely communicated and adopted by many.
The only difference in this “common sense emergency fund” advice is the amount of you should put aside . Most recommendations are around how many months worth of living expense or income you should have for the fund. It can differ from three months to twelve months with typically six months.
But, is it a really good idea to put money aside in an account that does not generate compounding fortune for you? Is there a better way to manage “emergency”?
In my point of view, the advice of putting such a large amount of money aside in a bank account that does not give you interest (or maybe a few dollars) is wasting money. The opportunity cost it carries is significant and needs to be addressed. In another word, I believe that the idea of of “emergency fund” is overrated. To get to deeper discussion, let’s take a look at the exact definition of “Emergency Fund” first.
Per Investopedia, an emergency fund is “an account for funds set aside in case of the event of a personal financial dilemma, such as the loss of a job, a debilitating illness or a major repair to your home. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to draw from high-interest debt options, such as credit cards or unsecured loans”.
So here you have it, it is a security fund to avoid, otherwise, borrowing money and creating debt in the case of “emergency”. It is an insurance for the peace of mind that does not necessarily in line with rationale of maximizing wealthy.
Now let’s take a look at opportunity cost you are carrying in order to pay for this “peace of mind” insurance.
Per U.S. Census Bureau, median household income is at an all-time high of $61,372 in 2017. Let’s say you put six month your income worth about $30,000 away in a bank account. Depending on where you are on your financials, there are typically two scenarios we can look into:
Scenario 1: You still owe high interest rate debt such as credit card debt
The average APR (or Interest rate) on new credit card offers remained at a record high with an average of 17.67 percent according to the CreditCards.com Weekly Credit Card Rate Report. $30,000 in credit card debt is paying $5,300 in interest. Would you even pay such amount to insure your house? I don’t think you would. The cost of emergency fund does not even come close to the interest you pay for your debt especially if the concept is “just in case something urgent”. With such cost benefit, it is easy to say that, if you still owe high interest rate debt, it is not a good idea to keep your cash in a no interest, or maybe couple of points above to zero checking account. There is no place that can pay you more than the credit card charges you in terms of interest rates.
Now we understand that this accidental insurance we pay comes at very high premium. It makes better sense if you simply use your cash to close out your debt. Being debt free will help you to get ahead in your finance. Below I will discuss what to do when you truly encounter an “emergency”. Emergency is supposed to be rarely incurred accident. When you owe debt, it is not rarely happening, it is constant and compounding if you don’t immediately take care of it or at least as fast as you could. It is the first priority above and beyond many other needs.
Scenario 2: You don’t owe higher interest rate debt
Now let’s move onto the next phase of financial management. You don’t owe debt and have no penalty or interest to pay. Should you put emergency fund aside into a bank account?
Now we are getting into the discussion of “accessibility” or “liquidity”. The difference between putting a large amount of money to a checking account vs. an investment is how fast we can get access to such fund to make us feel safe enough in case of emergency and the cost associated to it. There are many ways you can earn compounding interest or return to this fund and still enjoy the “accessible anytime” benefit.
Let’s say you purchased an index fund, a mutual fund, or even some specific stocks. All of them are sell-able at anytime you deem needed. The average index fund annual rate of return is around 7 percent. The higher end of mutual fund annual rate of return is around 13 to 14 percent. Both are liquid and don’t require active management. This is about $2000 to $4000 you are losing each year while your emergency fund sitting in a bank only to benefit bank portfolio return.
In addition to opportunity cost, another reason I don’t like the idea of “emergency fund” is that it complicates the portfolio management. I firmly believe that simplification is key to manage money. Looking at what you own and what you owe as an entire portfolio regardless the names of them. Your cash, checking account, saving account, insurance, 401k, roth IRA, house, income from your employer, day to day living expense, college funds, emergency needs… all of them should be simplified into only 3-4 accounts and be managed as a portfolio that I will bring more in depth discussion soon. The more accounts you own, the less power each account has, the more fees you might incur, the less compounding benefit you enjoy and the harder to even manage. Diversified portfolio by all means does not mean to spread your money around many accounts. Creating an account just for emergency is artificial and unnecessary. To have one more account only reduce your investment power that can compound to a bigger return.
So here you have it, despite of the popularity of “emergency fund” advocacy, I am on the complete opposite side of this advice.
But what if I lose my job or have an medical emergency?
Most employers offer “unemployment insurance” at no cost. Even if you have to pay for it, it is a fraction of the opportunity cost to emergency fund. “Unemployment insurance” is for emergency of “unemployment” that you should leverage. It is a true insurance and charged at insurance premium level.
Additionally, there is a social security unemployment benefit you could apply in the case of unemployment providing you actively look for a job. You have been paying for social security tax and contributing to this pool for the same reason that, one day if you need it, you can apply the benefit.
So leverage social security benefit, unemployment insurance while cutting down your expense is the route to manage unemployment emergency.
The same approach applies to medical emergency as well. Have medical insurance to pay for medical. Your insurance company more than likely can negotiate a better rate with health care providers than yourself anyway. If you are eligible, apply Medicare as well.
Even in the worst case, let’s say you exhausted all means of solving your living expense after consulting social benefits and other insurance. The only option left is to borrow money. At least you only pay interest for the time you actually use the loan, instead of paying a price each day regardless you use it or not.
Focus on the most important step to financial independence path, be debt free, before building emergency fund.
Emergency funds establishment is at different difficulty level depending on your phase of financial status. When you have a debt, nothing is more important than paying off debt first. Debt is an evil you should think of getting rid of as first task. The opportunity cost of spending when you carry debt is extremely high. This is when it is so called “cycle of the debt”. In a lot of cases, debt was incurred due to mis-management of spend. With more spend, you pay higher opportunity cost, which in turn creates more debt.
If you are carrying a significant debt, instead of worrying about “emergency fund”, solve the “emergency” at hand already, your debt.
Ironically, one day when you get out of debt and are in a better financial position, you already learned to better manage your money and live within your means. You will be less worry about “emergency” because of your ability of financial sufficiency. Rich do get richer.
To sum it up, make sense to your money and its ability to grow. Pay no interest and then work your money up to gain better return of investment. There is no reason to categorize your money other than don’t lose more money and make more of it through income and investment. It is this simple.
Simple Wealth For Women is a blogging website focusing on financial discussions. I help women to crush debt, learn how to invest and make more money. I show you simple approach and provide you with specific ideas to help you get to financial freedom and build an amazing life.
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