Here’s the latest post in the Rockstar Finance Money Match-Up series where two money bloggers argue opposite sides of an issue.
Today’s issue features another interesting debate — do you need a large cash emergency fund?
We’ll begin with Method to Your Money who says you need a large cash emergency fund…
Why a Cash Emergency Fund Is Better Than a Line of Credit
Along with such doozies as whether credit cards should be used for points or avoided like the plague and the debate between FIRE and FIOR, few topics in the personal finance world ignite more heated debates.
Let’s get one thing straight right off the hop – an emergency fund is NOT an investment.
If it were, the mathematicians amongst us proposing we invest our emergency funds and use a line of credit or credit card to cover expenses would be right. From a time value of money perspective, emergency funds are a huge waste of money.
But emergency funds are NOT a waste of money because they are NOT investments.
And because they’re insurance, there should be no expectation of receiving any return.
When’s the last time you were annoyed that your house insurance earned you 0% last year?
That’s right, because you didn’t expect it to return anything. You set that money aside (paying it to the insurance company) knowing full well that the only way it would ever “pay out” was if the unexpected and improbable happened.
Not Doing Nothing
But people get hung up thinking about emergency funds as an investment.
Well, a big part of it is because saving the recommended 3-6 months’ worth of expenses is a monumental task and a HUGE amount of money.
In reality, aside from retirement savings, it’s likely the largest amount of cash many of us will ever save. And it feels wrong, even sacrilegious amongst some personal finance bloggers, to have this money doing “nothing”.
Here’s the thing though. It’s not doing nothing.
Insurance, by definition, is a thing providing protection against a possible eventuality. And make no mistake about it, emergencies, while they can be rare, are eventualities.
Having access to a cash emergency fund provides an enormous barrier between you and the pitfalls and perils that life brings, perils which can put an immense financial burden on you and the ones you love.
And, as Dave Ramsey says, Emergency funds prevent “Murphy from moving into your spare bedroom and bringing his 3 cousins, Broke, Desperate and Stupid with him.”
My Yearly Emergencies
I know this is true from experience.
I live a relatively stable life (I do have 2 young kids, one who’s potty training right now, but that’s the biggest “emergency” I typically have to face on a daily basis). I have a great job with amazing job security (I’m a veteran teacher and administrator) and both my wife and I, and our kids, are healthy.
And yet, in the last 7 years I’ve averaged one $1000 emergency every year…
One time it was the water heater, and another it was an unfortunate incident involving our laptop and some piping hot coffee (it didn’t end well for the laptop). We’ve had unexpected deaths in the family requiring expensive flights, car repairs that went WAY beyond what we had budgeted for, and an iPhone die an untimely death in a mug of hot tea (note to self: personal electronic devices and hot drinks do not mix).
Having had the insurance of an emergency fund on hand made covering these expenses much less stressful.
It also gave me a sense of financial empowerment and pride knowing that I had planned and executed a strategy to protect my family from financial hardships. It made me feel good knowing that I didn’t have to borrow money from a bank and be at the mercy of a suited up B level bank manager.
Why Cash is King and Debt is Dumb
Aside from the inconvenience of having to go into the bank to apply for a line of credit (LOC), there are other great reasons to have a cash emergency fund.
First, while LOCs seem liquid, they’re not. They’re revocable, which means they can be frozen or shut down at the lender’s discretion or depending on the circumstances. Cash, on the other hand, cannot (barring criminal activity, a run on the banks or a zombie apocalypse) making it a superior choice for covering emergency expenses.
Second, taking on debt to survive an emergency is the equivalent of adding barrels of food to feed a starving castaway in a tiny life-raft. Yes, it solves one problem (starving) but it causes one just as fast (your raft will sink from the extra weight). Many people who recommend using the LOC as your emergency fund make several necessary, but not always realistic, assumptions.
- That people will actually open a LOC at the bank rather than just using one of the 3 credit cards the average person has. In reality, access to credit from credit cards is MUCH easier to get and it’s more convenient. Unless you’re in the 1% of disciplined personal finance geeks (term used with endearment) you’re not opening your own LOC just for emergencies.
- After you’ve covered your emergency with the LOC, you’ll “find” the money to pay it off. Speaking from experience, and looking at stats that say people are dangerously in debt already, paying off your LOC in a flash just isn’t realistic. People are living dangerously beyond their means. A 2016 study by the Federal Reserve revealed that 46% of people wouldn’t be able to cover an unexpected cost of $400. If you can’t afford to cover $400, where are you going to come up with the money to pay off the LOC? Oh yes, you say, I’ll cash in some of my investments and pay it off. Well for the 46% who couldn’t cover a $400 emergency, they don’t have money in their investments to do that.
- The money invested will always be increasing in value, not decreasing. Investments go up, and they go down. That’s how it works, especially if you’re invested in something you’re hoping is going to gain significantly more interest than a lowly savings account. But you don’t know what the markets will do. No one does, especially the people who say they do.
Life can be humming along nicely and then the unthinkable happens – AN EMERGENCY!!
The markets may have been experiencing a downturn over the last few months and your investment has lost significant ground.
You use the LOC to cover the expense but then you’re faced with a question.
Do you sell part of your investment at a loss to pay off the LOC or carry the debt balance for a few months in the hopes that the market will rebound and you’ll be able to sell for a profit?
This is a complicated question and one that you won’t have a good answer for unless you can see into the future, which you can’t.
The bottom line is, you don’t know what the market will do, and you’ll either sell at a guaranteed loss or gamble that the market goes up.
For me personally, I wouldn’t want to be in either of those situations, especially while I’m trying to find a roofing contractor to fix my sieve.
Bringing It All Together
At the end of the day, what makes personal finance so great, and so difficult, is that it’s personal.
Yes there are some black and white answers to money questions.
But more often than not, the best option lies in the grey.
If you are one of the personal finance nerds who would invest their emergency fund and use a LOC to cover the expense until you sold your investments to pay for it, more power to you. It’s financially risky and it adds unnecessary stress to your life, but if that’s what floats your boat, hop in and start paddling.
For me though, I LOVE the feeling of knowing that I have cash set aside for when emergencies strike.
It’s not a matter of if it will rain. No, it’s just a question of when and how hard the downpour will come.
I sleep like a baby knowing I’ve got a giant umbrella at the ready to protect me and my family. And for me, that insurance is worth every penny of lost investment gains.
Now let’s hear from Money Beagle who favors a small cash emergency fund…
On Holding Less Cash In Your Emergency Fund
Over the years, I’ve seen many arguments for and against a big cash based emergency fund.
First, let me say that I definitely think that an emergency fund is important! The question, though, is just how big it should be.
How much cash do you really need?
My Shifting View
When I really got going on Money Beagle back in 2009, I was all for a big emergency fund. At that time, I had an emergency fund of $10,000. We kept this in a money market account, which at the time was earning about 5% annually.
Now, we still have a dedicated emergency fund, but it currently totals around $2,000. At least this is what we have earmarked.
We’ve reduced our fund by 80%. Yikes, right? Nope. I’m actually totally OK with that. So, what’s changed? Why have we cut our emergency fund 80%? Especially since we now have two kids. Let me explain the rationale behind our shift in the emergency fund savings, and why I don’t think a big cash emergency fund is for everyone.
Credit and Insurance
Most emergencies are going to hit you with an unexpected cost. The issue is how do you pay for that emergency? Over the years, I’ve found that the initial cost of emergencies can be paid for either with credit or insurance. If your house floods, you’ll get a check from the insurance company for most of the damage. The rest can be charged to your credit card. The same holds for an auto accident.
Bottom line, a credit card is a comfortable buffer to get you through the emergency period.
Cash and Other Allocations
While many may consider it risky to hold a small emergency fund, those who are conservative with their money will agree with me on one thing: Savings. We save for all major purchases. When we need to replace a car, we tap our New Car fund. If we need a new roof, our Home Repairs fund is there at the ready.
These are all cash holdings, and I’ve realized that cash can cover many different things. And, in some cases it would cover both. If we totaled our car and had to get a new one, not only could we tap our emergency fund, we could tap the New Car fund. Which we probably would have to anyway.
In just about every case where we considered using Emergency Funds for an unexpected expense, we ended up having the money set aside already in a different fashion.
So, a dedicated emergency cash fund could actually be a tad redundant.
In addition to cash, many people also have some investment holdings. We don’t have much here, but we do have is unallocated for any particular expense or savings category. If worst came to worst, these funds could be tapped to cover an emergency situation.
Many people don’t feel comfortable with this, because it can take time to clear your investments. This is true, but that’s why being able to put the expense on a credit card, as alluded to earlier, can manage this risk. By the time your credit card payment is due, your funds should clear.
You Can’t Account For Everything
In the examples I’ve given, we’re covering emergency fund needs in three layers of funding: A small emergency fund, cash for savings, and investment. Now, many people may not have these, or may have different categories that could come into play.
Nobody can predict the scope of an emergency. If you could see what your needs would be, it probably wouldn’t be an emergency, after all! So, I feel that some cash is important, but a large amount simply isn’t a wise use of funds. These days, putting your money to work is more important than ever on the path to financial freedom.
Having some cash on hand is important, but I do not feel a large cash fund dedicated strictly to emergencies is the best use of those funds. A modest emergency fund backed up by available credit, savings for other items, and investments is a strategy I’d stand behind.
So, those are the two sides of the issue. What do you think?
He’s an early 50’s retiree who achieved financial independence, shares what’s worked for him, and details how others can implement those successes in their lives. He is also the author of a free ebook titled Three Steps to Financial Independence and spends a lot of his time interviewing millionaires.