Monday, November 1, 2010

The Hidden Cost of Emergency Funds

"Emergency Funds" - It seems like just about every financial advisor these days wants to tell you you are doomed (DOOMED!) if you do not have an emergency fund.  Most of them agree that an emergency fund is an amount put aside in a savings account or money market that you can quickly access in case of emergency.  How much?  Well, some say 3 months, some 6, some 8 or 9.  Also, some base the number on living expenses and others base the number on salary.

I say that emergency funds - as envisioned by the "experts" - have significant hidden costs (100K+) over the life of the average employee.  Also, there is no need for the "expert's" vision of emergency funds.  The average person can set up something that provides more value with no loss of timeliness of access.  Read on below.

First, there is a definite cost to having an emergency fund, although people often miss it.  To understand the cost better, let's take a look at the following example.

Let's say you are a newly minted law school grad who won the big-firm-job lottery and have a job making $160K/year (most likely loans in excess of $200K, but that's another article).

You want to be a "good planner" and "everyone knows" that you need an emergency fund, so you decide to put 6 months of salary - $80K - into an emergency fund.  Let's ignore for the moment how many years it would take you to accumulate $80K after taxes and just pretend that someone just gave you $80K.

So you take the $80K and proceed to put it in a savings account.  Unfortunately, the savings account is not paying very much - ING is one of the best and is only paying 1.1%. On the other hand, you could have invested the $80K in a mutual fund, such as the SP500.  Now, the SP500 has gotten a bad rap lately because it's total return from the time of the hyper-inflated values of 2000 to the depths of the crash in 2008 is not great.  However, recall that the common suggestion is that one have an emergency fund over one's entire working life, which would probably be around 30 years.  Further, we know that the current 30-year rate of return for the SP500 is around 7%.

This should make obvious that keeping an "emergency fund" is actually pretty costly in this situation.  More specifically, the cost is the difference between the 1% you get with savings and the 7% you get with the SP500 - that's about $4,800/year - which is pretty sizable.

Second, let's take a look at some alternatives to an emergency fund - namely credit cards and home equity lines of credit.  With a home equity line of credit, the bank offers to lend you up to a certain amount based on the equity in your home.  These arrangements typically only charge interest when you are actually using the line of credit.  For example, let's say that I have a house (or condo) worth $300K in which I have 70% loan-to-value (I owe $210K).  In most areas, banks are willing to give lines of credit up to 80% LTV.  Consequently, I could acquire a home equity line for $30K and just let it sit there until I need it.  No interest is charged until I actually need it and many banks don't charge a yearly fee - or charge a very low fee on the order of $50.

In comparison, if I had put $30K in an emergency fund, the true cost would be the lesser return that I would earn relative to the SP500 - which would be about $1800.  You can see that the home equity line is much cheaper in this situation.  As far as speed of accessing money, typically home equity lines come with a checkbook, so the speed is the same or better than a savings account.

Another option is a credit card.  We don't want to have to pay interest, but we typically have 30 days from the time of the charge to make changes in our behavior to save any money that we might charge or to find assets some other way.  Also, it's not the end of the world if we have to pay interest for a month or two - especially if it allows us to make money somewhere else.

For example, consider someone who decides not to have an emergency fund, but ends up having to charge $2,500 of transmission work on their car.  Let's say that after paying their rent, utilities, and loans they typically have $1,000/month left over for food and fun - of which they spend $500 on food and $500 on fun.  Once the transmission charge hits, they eliminate the fun budget and cut the food budget leaving a monthly amount of $700 to go toward the card.  Assuming that the expense hit in the middle of the month (average), they will have paid down $350 of it before the remainder starts accumulating interest.  Let's say that the interest rate is 18% (1.5%/month) - which is fairly high.  The first month they start with a balance of $2150 and $32.35 in interest accrues leaving the balance at 2182.35.  After their second payment they are at $1482.25 and $22.23 in interest accrues.  Next month $804.48 and 12.07 in interest.  Next month $116.55 and $1.75 in interest.  Over the entire time, the person has paid $68.40 in interest.  That may seem like a lot, but if you compare it to the $1800/year loss by keeping your $30K in a savings account rather than the SP500, it's really not much at all.

As a third alternative, how about just putting that $30K in the SP500 directly?  This would spare us the 6%/year in lost gain on average.  It also does not typically add much time in getting access to your money.  For example, both Vanguard and Fidelity allow me to cash out and electronically transfer from their mutual funds to my bank in three days.  Turning it around, how big of an emergency must it be that you can't wait 3 days for your money?  Or that you can't just charge it and pay it off three days later.

Third, let's take a look at some actual costs that the emergency fund is supposed to be used for and compare the use of an emergency fund to the use of a credit card + investment.

"Car problems" or an appliance breaking are one common example. You need the money right away, but a credit card is just as good as a savings account for immediate access - if not better.  If you have the $30K invested, you are making 6%/year more ($1800) on average.  You could probably pay for the car problem or appliance just from the earnings that you make by investing your money and making it work for you instead of letting it be lazy money in a checking account.  If you feel that you need to tap the invested funds, you can have them in 3 days.  It's a little delay, but well within any time period for payment of the credit card, so there should not even be any interest.

Loss of job - In today's difficult job market, unless you are very lucky or have a very large emergency account, you are going to have to tap your investments - spending more than 6 months out of work appears distressingly common.  However, recognize what happens over the course of your working life with regard to the cost of keeping the emergency fund.  If you have invested the money at an annual return of about 7%, then it doubles in about 10 years.  To put numbers on it, if you start with $30K in an emergency fund (at 1%) vs. invested (at 7%), then in 10 years your emergency fund will be about 33K while your investment will be about $60K.  After another 10 years, your emergency fund may be up to $37K while your investment is at $116K.  After 30 years, it's $40K vs 228K.  After 40 years it's $44K vs. $449K.  Subtracting those numbers at the end of 40 years indicates that if you keep an emergency fund of $30K for the 40 years of your working life vs. investing it, you miss out on about $410K.  Keeping the $30K as lazy money in a savings account has cost you plenty.

In conclusion, I don't recommend keeping an "emergency fund" in a savings account or other low-earning investment - it costs you too much money.  Instead, keep your credit card if you need a short-term loan and put that money to work in a reasonably stable, decent return investment like the SP500.  Let me be clear - I really value saving money each month and everyone should endeavor to have a large chunk of money set aside.  However, when you assemble that chunk of money, put it to work!  Don't let it languish in a savings account - especially when 1) there is no advantage to the savings account for the purposes you are going to put the money to, and 2) you are losing a very significant amount of money yearly due to lesser investment return.


  1. So, given the reality that the average associate is using all 'extra' money to pay student loans and probably isn't saving much more than max 401(k)/IRA contributions (if that), do you advocate having a separate non-retirement brokerage account for emergency fund purposes, or is it good enough to have the ability to borrow from the 401(k)/withdraw from the IRA if needed? This isn't hypothetical; I'm a second year associate with about $50,000 in retirement savings, a few hundred in a traditional brokerage account, and never more than $2,000 in the bank. A HELOC isn't an option, as I live in NYC and rent.

  2. 11:26 - Thanks for the comment - please see the new post that I did on it!