Disclaimer: If you’re not at the point where you’ve started investing and are still working on paying off credit card debt, at this stage in your financial life, an emergency fund may make sense. Other then that I think they are generally unnecessary.
If you follow some of the personal finance bloggers and podcasts, you might come to the conclusion you need to be subsisting on nothing but beans and rice (or lentils) until you’ve established the obligatory Emergency Fund. The emergency fund typically being described as somewhere between three to nine months of expenses saved in something highly liquid like a checking or savings account to make cash readily available at moments notice to fix your emergency.
This advice has become cannon in the personal finance community and questioning it will usually be met with ridicule. The only problem is that for many it’s simply bad advice. Why? Once you’ve reached the point where you’re investing, the emergency fund simply adds unnecessary complexity and worse, you’re missing out on returns.
Unplanned expenses happen in life. Believe me, I get it. Cars break down. The IRS send your a bill because you made a mistake on your return a few years back. You have a costly medical problem. Or maybe the roof collapses and you need to make repairs. My issue is that these things aren’t totally unforeseeable and they do have remedies that don’t require you to keep six months of cash in a checking account.
you might come to the conclusion you need to be subsisting on nothing but beans and rice (or lentils) until you’ve established the obligatory Emergency Fund.
If these things are somewhat foreseeable that makes them a bit difficult to categorize as an “emergency”. If problems in life are somewhat foreseeable then it makes sense to prepare for them before they happen to contain the potential cost.
YOUR FIRST LINE OF DEFENSE: PREPAREDNESS
A bit of living will teach you that it’s wise to prepare for the unexpected and there are remedies against being wiped out financially for many of the so called emergencies we are likely to face. A brief overview of some are below.
Unless your car is less then two years old, it doesn’t take a trip to the psychic to see that there’s a fairly reasonable chance that you might have to make a repair up to a couple grand if something goes wrong with the car. Does this register as an emergency? Well for the very near term you could always get a ride, take an Uber, use public transportation, ride a bike, or walk. If your car needs to be repaired immediately you can put it on a credit card, and pay off the balance in thirty days.
It’s also worth noting if your car was damaged from an accident where you weren’t at fault, you might not be responsible for paying for the damage anyways. Also, some unplanned car expenses might be paid through your car insurance.
I sympathize with anyone that has expenses due to unplanned medical care as I know how outrageously expensive it is to get medical care in the US. That being said, there’s ways to approach the problem rationally to help curb costs. (One of them is to leave the US and get care elsewhere)
Health insurance is there to keep you from getting stuck with a $15,000 bill from unexpected medical expense. Of course all medical insurance varies, but many employers have plans that allow you to elect to save contributions to a health care reimbursement account and set aside up to $2650 a year. This will help you meet most deductibles and certainly help with paying the bills as they come in.
If you’re not employed you also may be eligible for Medicaid.
Job loss certainly can occur for all of us, but it’s often not as unexpected as you might imagine. These days employers will typically put you on a “performance improvement plan” for 30 to 60 days before terminating you which gives you a bit of time to plan for the loss of income. Additionally, if you’re let go through no fault of your own, you generally will be eligible for unemployment income. Look into the rules for your state but in most cases, as long as you aren’t terminated for gross misconduct you are eligible for unemployment.
PAYING YOUR EXPENSES
While some planning will go a long way, there’s no doubt about it. Unplanned expenses definitely happen and you’re going to need to pay. But how?
Paying for your unplanned emergencies, is not really that different from paying for most of things you normally expect in life. The conventional wisdom of paying for unplanned expenses with an “emergency fund” brings to mind some contradictions that go against other teachings of the personal finance community.
Paying for expenses with a credit card is often the best way to pay for things. Planned or Unplanned.
When you pay for any and all expenses with a credit card you have consumer protections. Whether it’s a planed consumer electronics purchase, or a repair to your vehicle, you typically have consumer protections. That means if someone rips your off or doesn’t provide the service or product as described, the credit card company can go to bat for your and you don’t pay unless the merchant can prove the charge is valid.
Credit Cards give you the float time period. We’re talking unplanned expenses here right? Well paying with a credit card gives you usually between 20 to 30 days of a float period to actually pay out the cash. This will give you additional time to come up with the funds from a paycheck, or tapping savings or investments, or selling something if you must.
Credit Card rewards points. If you pay for your unplanned expenses with the right credit card, you’re likely to get a discount of around 1 to 2%. So you could knock that $2000 car repair bill down to $1960. Every little bit helps with an unplanned expense.
The Financial Cost of Keeping the Emergency Fund
Conventional Wisdom these days calls to keep the Emergency fund in something very liquid and easily convertible to cash at a moments notice. I usually hear it should be a checking account, savings account, or money market account. The rates these days for checking accounts range from nothing to very low. Savings and and money market accounts are marginally better. But the cost of having un-invested cash sitting there for years or decades is called cash drag.
This is another one of the contradictions in the personal finance community. The community swears that it’s critical to keep investing expenses as low as humanly possible and does so with Vanguard or other low cost index funds. But then is willing to turn around accept 3 to 9 months of life expenses sitting in a checking account earning nothing. Consider the cash drag to be the equivalent of having a higher expense ratio mutual fund you’re invested in. Opportunity cost is still a cost.
THE MENTAL COST
There’s a hidden mental cost to maintaining an emergency fund and to me it’s the main reason to avoid it. It simply adds unnecessary complication to your life. If you’re the typical adult that is focused on doing life financially prudently, you may have already accumulated the following accounts.
- A personal checking account
- A 401k
- A Roth or Traditional IRA
- Credit Cards
- An employee stock purchase plan account
- A joint checking account
- A Taxable investment account.
If you have business ventures, you may have other accounts as well. Adding yet ANOTHER checking account just introduces more complexity to your life with little value.
PAYING OFF YOUR CREDIT CARD
So if you’re saying to use a credit card pay for your unplanned expenses, there’s certainly a few of you out there saying “BUT HOW THE HELL DO WE PAY OFF THE CREDIT CARD!?” The answer is your pay off your credit cards from liquidating assets in your taxable investment account.
Don’t get me wrong, I’m not saying don’t have savings. I’m just saying once you’ve reached the point where you have an investment portfolio, a portion of you investment portfolio should be invested conservatively. Think a mixture of bonds and some being short term. If the unplanned expense hits, you liquidate some short term bonds. I typically hear that the reason to have an emergency fund is “What if your emergency happens when the market is down? I’ll be selling at a loss” Not true. Bonds are stable and don’t fluctuate in value like stocks. This not only means you’re unlikely to have a loss it also means you’re unlikely to have to pay taxes with a capital gain. Short term bonds are ideal for funding unplanned expenses. And they need not live in a separate “emergency” account. They can simply be a portion of the investment portfolio.
So how do you pay off the credit card? You sell your short term bond funds. You wait for the funds to settle which might take 3 or 4 days. You transfer this money to your checking account. Then you pay off your credit card expenses with the money which is now in your checking account.
The most absurd reason I’ve heard about needing an emergency fund is liquidity or the urgent need for cash within 24 hours. Setting aside that an ATM won’t really let you withdraw more then $400 a day in most cases, I’m still struggling to imagine what the situation is that requires one to write a check or come up with cold hard cash and fund a six month expense within 24 to 48 hours. Arrested? Bail bondsmen take credit cards. Medical bills come in the mail typically over a month later and can be paid with credit cards.
What I’m left with, is getting into kidnapping ransom type scenarios. This might be a legitimate reason to keep 6 months cash in a checking account if you’re at risk. But then let’s quit calling these emergency funds and just call them kidnapping ransom funds.
Subscribe To "Go Catch Life"
Join the mailing list to be notified when I've created a must-read post. Get a FREE list of money making tips as well.