If you frequently read articles, books and blog posts about personal finance – as is my unfortunate wont – you quickly stumble upon one of the sacred cows of the genre: “The Emergency Fund.”
“The Emergency Fund,” the grown-ups tell us (as in this post that showed up in my inbox yesterday,) consists of 3 to 6 months of wages, socked away in a safe CD or savings account at the bank, untouched by regular expenses. Only when you stumble to the emergency room for your uninsured, unplanned, uninvited $5,000 appendectomy, or only when you lose your job and take 6 months to land a new one, are you allowed to dip into this account.
This sacred cow of personal finance, however, deserves to be cow-tipped at midnight. Because, mostly, its a complete load of bullcrap.
I’m not saying it’s a bad idea to have some ready money in the bank. Of course it is a good idea. Money in the bank is lovely. The idea is fine. But it stinks as a piece of personal finance advice.
In reality, there are three types of people, and none of these three types need the ‘Emergency Fund’ sacred cow advice.
Group One – You have money in the bank, (or stocks in the market, or a trust fund annuity, or whatever) without having been told. Maybe you were a fortunate beneficiary of the genetic lottery and tax code (The first $5.5 million inherited is tax free!), or maybe you just have a squirrel-like capacity for storing nuts. Good for you, but you really don’t need to be told about the Emergency Fund rule. The advice is irrelevant. You’re past that, you got that covered.
Group Two – On the edge of solvency, trying to make it through every month with all bills paid, but occasionally slipping into deficit. This includes about 50% of all Americans and 90% of Americans under the age of 30. This is the group to whom the “Emergency Fund advice” gets directed by the concerned grown-ups with a furrowed brow.
Now, this Group Two might, theoretically, be interested in the advice, but it really doesn’t even make financially savvy sense to follow it.
Here’s the mathematics of why. If you’re at break-even financially, with occasional monthly deficits, then you’ve got some credit card debt. You’re like 55% of Americans who carry a balance from month to month. You might pay the national average of 12% on that credit card principal balance. If you’ve got a checkered pay history you’re looking at 18% to 29% interest on the balance.
To make the math easy, let’s assume you have $5,000 in credit card debt, on which you pay 15% per year in interest, which totals $750 per year in interest.
Ok, now let’s say you somehow, despite paying significant interest on your debt burden, manage to accumulate a $5,000 Emergency Fund, just like they told you to. Congratulations. Now the adults convince you to ‘do the right thing’ and put it in an untouchable savings account.
Here’s some more easy math: You can safely earn up to1% annually on that Emergency Savings, or $50 per year.
So, in sum, the sacred cow advice is to pay $750 per year in interest while earning $50 in interest? Let’s just lock in a $700 loss per year! So even for this group, to whom the advice always gets passed, it doesn’t make sense.
What makes financial sense for Group Two, instead, is to have close to zero savings, but also to have close to zero credit card debt, with open lines of credit to be drawn on in an emergency. In that scenario, you neither earn interest nor pay interest, and you’re certainly not safe and comfortable, but at least you don’t lock in an annual $700 loss on your money, due to bad advice.
Because let’s face it: If you’re in Group Two, the choice isn’t between having an Emergency Fund or not. The choice is between having high-interest debt on the one hand and low-interest savings account on the other while paying the difference to your bank(s), or having neither and keeping the money yourself.
In a related story, nobody in Group Two actually has an Emergency Fund.
Group Three – Totally indebted, with no prospect of savings. This includes the chronic under- or unemployed, anyone whose house is in foreclosure, or is bankrupt, or not paying their credit card bills. At any point in time this is going to include about 25% of all Americans.
Yes, an Emergency Fund would be fabulous, but it’s totally irrelevant for this group.
I know I’m being flip and overly simplistic about this, and for the five readers who are about to write in to tell me about their emergency fund and what a great thing it has been for them, I apologize in advance.
You know who really likes the ‘Emergency Fund’ advice? Those five people. The ones who already have one.
You know who else really likes the ‘Emergency Fund’ advice? Banks, because they can earn the interest rate spread between your debt and your savings.
But for the 299,999,995 other people who have done the math on the classic Emergency Fund advice and agree with me: Respect.
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