Why I hate emergency funds
I hate emergency funds. I hate them with a firey passion for the simple reason that they’re recommended to financial and investing newcomers without a solid discussion of the benefits, risks, potential problems or alternatives. I have come across FAR too many people who have $30-60k sitting in a checking account because they read something online or a ‘wise’ advisor told them they should have one because…SCARY REASONS.
Let’s start out defining the purpose of an emergency fund so we can narrow in on why so many of the recommendations are problematic.
The purpose on an emergency fund is to provide liquid financial assets in the case of an event such as a job loss, illness, natural disaster, etc. Those assets should be accessible quickly without high penalties, taxes, fees, or interest charges and should provide enough liquidity to cover several months of expenses. – Grizzly Dad
This sounds like great advice! And it is great advice. You definitely want to have something that looks like what I just described above. It’s vital that if you face an actual emergency that you are able to quickly access the resources necessary to keep your family healthy, happy and financially stable. And you need to be able to do this without resorting to options like high-interest credit cards, stocks with large amounts of unrealized capital gains, payday loans, or god forbid retirement plans that carry an immediate 10% penalty. However, too often this advice gets reduced down to:
You need to have six months of expenses sitting in a checking account as liquid cash earning near 0% interest – Lots of dumb people and many financial advisors
This is terrible advice. Let’s talk about why. The specter haunting all of this is inflation and rock-bottom interest rates. Essentially, this advice all but guarantees that you will lose purchasing power and miss out on returns over time on a significant chunk of your assets. This is not a good thing and will make you poorer over the long run.
So what is inflation and why is it so dangerous? Inflation is the main reason a loaf of bread cost 10¢ in 1940 and $3 today. It is the gradual upward movements of commodity prices over time.
There are volumes of economic literature written on whether inflation is a good or bad thing for an economy (I generally tend to believe a small stable rate of inflation is a good thing). But that is a discussion for another day. What we need to acknowledge here is that inflation exists. A dollar will get less valuable over time at a slow (and sometimes fast!) pace.
So how bad is inflation? We’ll go back to one of my favorite data sources – FRED, the St. Louise Federal reserve bank’s awesome database of economic info. The graph below is the inflation rate every year going back to 1955. We’ve been in a period of relative stability since the 1980s, but massive spikes do happen. The average rate of increase has been about 3.8% over this period. Over the last 30 years, that has moderated to an average of 2.7%. 2.7% of the value of a dollar eaten away every year.
So how serious is this? Very serious. At this rate inflation eats away almost 25% of the value of your investment over 10 years.
The current interest rate on your average checking account will not catch up to this. The current rates on checking and savings accounts are hovering around .06% and .04% nationally. Yes, there are some higher interest options available, but even the caps are only sitting at around 1% right now. Still losing money to inflation every year. Putting a large portion of your assets into a checking/savings account is an almost certain way to lose 2-3% every year. This is a terrible investment. And any financial advisor that suggests it should be fired immediately.
So if putting 6 months of expenses in a checking or savings account is a bad idea, but maintaining at least some liquid financial assets is a good idea, what should you use?
There are a number of better options than just sticking everything in a checking account. Options that will keep up with inflation and prevent you from losing money every year.
Treasury Inflation Protected Securities or I Bonds
This is the simplest and lowest risk option out there, and what I would recommend for someone just starting out that can’t afford to lose any of their investment and doesn’t have the assets necessary for other options.
Inflation-protected securities are bonds issued by the federal government that do just what their name describes. They protect the owner against inflation. Essentially TIPS are designed so that if inflation occurs your investment is protected and increases along with it. There are two ways that I recommend purchasing them. Directly from the US Government through the treasury direct program or even more simply through a Vanguard index fund.
I-Bonds are also available directly from the use government through treasury direct. The only problem with I-Bonds is that they have a few more restrictions placed on them such as a 1-year lockup period and an interest penalty if you sell before 5 years. Overall I recommend the TIPs but these also work.
A dirt simple bond mutual fund like the Total Bond Market Index fund offered by Vanguard is a perfect place to house assets you need to be stable and accessible. A bond fund like this is not guaranteed to keep up with inflation like the TIPS and I-Bonds above, but in most circumstances it will, and it will almost always deliver a higher return than a simple checking or savings account.
Line of credit on a primary residence
A third option available to homeowners is simply a low-interest home equity line of credit on their primary residence. You can open one up at the bank that provided you your mortgage, or shop around for the best rate. If you ever have an emergency need for cash tap into the line of credit and pay it back once you have regained your footing.
Yes, there will be a small interest rate charge for using this method, but taking that in the rare circumstance in which you need it is much better than maintaining a high cash balance you are certain to lose money on every year.
View your emergency fund as part of a larger portfolio
A slightly more advanced concept but the one the Grizzlies employ. We view our assets as one central pool regardless of which accounts they sit in. We allocate those assets as best we can to maintain safety while also maximizing our net worth over time. This strategy should only be employed once you have a decent amount of assets available. 3-4x your annual expenses.
When looking at our portfolio holistically, we would never choose to maintain a large portion of it in cash. And therefore we don’t. We have selected the mix between safer assets (bonds) and riskier assets (stocks) that we feel is optimal to maintain. If we were to ever face an emergency we would simply liquidate portions of our portfolio and maintain the same relative balance across all of our assets.
The argument against this that is often brought up is, “What if you have to sell off in a down market!?!” Our answer is, “so what?” Just because the market has dropped slightly or the fact that there is a sudden need for cash doesn’t change what we view to be our optimal allocation of assets for our long-term wealth. If the market has dropped then we’ll happily pocket the capital losses and use them to defer income or capital gains in the future.
High cash back credit card
The final objection to all of these suggestions is “What if you need the cash immediately!?! In the next hour!”. All of the above suggestions have at least some lag time before the cash can be accessible in a checking account. The answer is to maintain a high cash back credit card with a high limit for expressly this purpose. We use the Citi double cash back card (review from NerdWallet). If you have unforeseen expenses, put them on the cash back card. Transfer the money from your investment accounts. Pay off the card immediately.
Emergency funds are great in concept – savings that enable you to ride out difficult situations. But in practice, they are often implemented in such a way that they cost their owners significant amounts over the years. There are much better ways to ensure that you and your family are protected in the case of sudden shocks.