I’m a pretty big advocate for emergency funds – cash stowed away in a savings account for a rainy day. Establishing an emergency fund is one of the first things Sarah and I did during our financial turnaround and that emergency fund took care of several difficulties we faced during the first year or so of our financial turnaround.
My belief is in line with that of Dave Ramsey: the first move anyone should make when they’re facing the reality of their debts for the first time is to save up a $1,000 emergency fund. Later on, when you have high-interest debts out of the way, a larger emergency fund is even better.
Even so, there are arguments out there against emergency funds, stating that they’re not a particularly good idea. Those arguments usually rest on three key points.
First, emergency funds stowed away in savings accounts do not earn a good return. Savings accounts earn somewhere between 0.5% and 1.5%, depending on your bank. You can earn a much stronger long-term return in other investments, such as the stock market which historically has returned somewhere around 7%. You would be foolish to make cash savings a significant part of your investment portfolio.
Second, most people have credit available to them, so they should use that in an emergency. If you’re facing a situation that you can’t cover with cash, you could simply use the existing credit on a credit card to cover it. After that, you can pay off the credit card quickly.
Third, emergency funds are a terrible idea if you have high interest debt. A debt sitting at 20% is costing you far more than the savings account is earning for you. You should pay off the debt first.
Here’s my take on each of these points.
First, everything you invest your money in excels in two of three areas and fails in the third one. An investment is either low risk, has a high long term return, or it’s highly liquid (meaning you can get your money out very quickly). You can choose two of those things with almost every investment.
A savings account provides the two things that you’re really looking for in a time of personal crisis – it’s low risk and it’s liquid. The high return is much less important because you shouldn’t be keeping a significant portion of your net worth in an emergency fund. It’s not an investment – it’s a buffer against an emergency.
Right now, our emergency fund makes up only a few percentage points of our net worth. Even when we first started our financial turnaround, we only established a $1,000 emergency fund, which was still only a small fraction of the total value of our assets.
An emergency fund is simply a sacrifice of returns on a small portion of your money so that you have something on hand that’s very liquid and very low risk. It’s not meant as a major part of your retirement savings or your investment strategy. It’s meant as a buffer against things that might happen to you.
Second, trusting in a line of credit means trusting completely in the discretion of a bank. It relies on your credit report remaining clean – untimely identity theft can wreck your credit report for a while and leave you without that credit. It also relies on the business policy of the bank remaining constant, which isn’t a promise – many banks have lowered credit limits over the past several years on large numbers of their customers.
Another problem with this angle is that using a credit card has a strong likelihood of meaning that you’re going to be paying a high interest rate when you pay it back. Yes, there are many emergencies where you’ll be able to pay it all back before the interest kicks in, but what about unemployment, for example? The average duration of unemployment these days is about 36 weeks. It’s pretty likely that you’ll accumulate a nice pile of debt and interest during that kind of timeframe – and, ideally, the bank won’t notice and cancel your line of credit.
A further problem is that many Americans simply don’t have adequate credit to rely on the banks in an emergency. According to this report, 33 million Americans have insufficient information on their credit report to generate a credit score, 24 million more Americans have no credit history whatsoever, and another 61 million Americans have a subprime credit score. That’s 118 million Americans who have insufficient credit with which to obtain a credit card. These are not people who can safely rely on the bank extending sufficient credit to them.
Beyond that, simply having a good credit score isn’t a guarantee that your credit may not fall during a time of crisis. 72% of Americans live paycheck to paycheck – as soon as their paycheck disappears for even a week, bills aren’t getting paid and their credit starts to drop pretty quickly thereafter. This isn’t really a group that should rely on banks extending credit, either.
Finally, repaying debt is more than just a math problem. To start off the explanation here, I’ll quote Dave Ramsey from The Total Money Makeover, page 105:
“Since I hate debt so much, people often ask why we don’t start with the debt. I used to do that when I first started teaching and counseling, but I discovered that people would stop their whole Total Money Makeover because of an emergency – they felt guilty that they had to stop debt-reducing to survive. It’s like stopping your whole fitness program because you get a sore knee from a fall when running; you’ll find any excuse will do. The alternator on the car would go out, and that $300 repair ruined the whole plan because the purchase had to go on a credit card since there was no emergency fund. If you use debt after swearing off it, you lose the momentum to keep going.”
When you’re first trying to do something to improve your life, it’s incredibly hard. It’s very easy to be pessimistic about it and be skeptical that things can ever really change. When you hit that first roadblock, it can be incredibly tempting to just simply quit. I’ve seen a lot of people – including myself – abandon goals at this point.
It is well worth sacrificing a relatively small amount of financial gain in the short term to significantly decrease the chance for roadblocks to stand in your way over the longer term.
Once you’re past that point – you’ve paid off your high interest debts and you’re saving and investing for big future goals – good financial decision-making can feel as easy as riding a bicycle. However, a person who is just taking the first steps to a turnaround is much like a child learning to ride for the first time, and the emergency fund is like a bike helmet and training wheels. Sure, they might get going a little faster without them if everything goes perfectly, but life isn’t perfect. We all stumble. It’s a lot easier to get back up and jump in the saddle if you’ve got something in place to cushion your fall.
During that period where you’re saving up a $1,000 emergency fund, you are absolutely causing yourself to build up more interest on your credit card because you’re not paying it off, but you’re doing so to prepare yourself for success in paying it off. What you’re doing is spending a few moments to strap on your bike helmet before you jump on board. Sure, you probably won’t be the first one to the end of the block, but you’re also going to be far less likely to give up when you fall off your bike because the mistake won’t hurt nearly as much.
A final point: most of the arguments here don’t mean anything to you if you don’t really believe emergencies can happen to you. Different people have different levels of safety nets in their life. Some people can rely on their families for financial support no matter the situation. Others have an employment background and connections that are basically infallible. Still others receive a very high income combined with at least a basic understanding that they need to save or invest at least a little of it. For those people, a $1,000 emergency fund is going to seem rather unimportant.
On the other hand, all I have to do is look back at some of the experiences of my own childhood to see how an emergency fund can make a tremendous difference. My father was often laid off from his job and during those times an emergency fund sustained our family. My old man diligently put aside a little bit of money directly from each of his checks into a credit union and we used that credit union when times were tough. The day-to-day reality of my parents’ life didn’t involve investing in the stock market. It involved making sure food was on the table and handling many little emergencies by the skin of their teeth.
Like it or not, half of Americans live in what is considered a low-income situation and, as I stated earlier, 72% of Americans live paycheck to paycheck. These are people that, in many ways, share the experience of the household of my childhood. Turning the ship around isn’t going to be easy for them. Putting on a helmet before they hop on that bike is going to make a big difference.
If you’re figuring out what your first step should be in terms of turning around your debt situation, my recommendation – and Dave Ramsey’s, too – is to have a $1,000 emergency fund. Consider it your helmet for the bicycle you’re about to learn to ride.