We hear all the time how Americans are not saving enough for emergencies. The “Emergency Fund” is heralded as the first step in getting a sound financial footing, before thoughts about investing in stocks or making large purchases enter the brain. The idea of putting aside cash for a (very) rainy day has been a hot topic in the blogosphere lately, especially with regards to the Katrina tragedy.
Here are some facts (from an article on MSN):
- 43% of households have less than $1,000 in liquid savings, according to SMR Research, a market research company.
- 28% live literally paycheck to paycheck, an ACNielsen poll found in August, with no savings whatsoever.
- Just three in 10 households have a cash hoard that would tide them over for a minimum of three months, according to Ohio University researchers.
It sounds pretty dire. But Liz Pulliam Weston, the author of the article and of the book Deal With Your Debt: The Right Way to Manage Your Bills and Pay Off What You Owe, says financial flexibility is more important than cash on hand. Here are her drawbacks to cash Emergency Funds:
- Emergency funds take a long time to accumulate.
- For many families, saving for emergencies has an unacceptably high opportunity cost. That is to say, the money being saved in an emergency fund doesn’t hold the same future value as money invested elsewhere.
- Some people don’t want to have cash sitting idle. Taxes and inflation eat away at cash.
- A big pile of cash still might not be enough.
Liz has two suggestions for alternatives to Emergency Funds: credit cards and home equity lines of credit (HELOC). First of all, if you’re not a homeowner, a HELOC is right out of the question. I’m wary about the idea of using a credit card for emergency spending. If the emergency lasts for a while, and if credit card companies’ practices remain the way they are, it will not take long to become buried in debt for the rest of your life.
My conclusion: Yes, there are drawbacks to keeping six months’ expenses in cash or cash equivalents. It’s a risk I’m willing to take.
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12:26 pm (reply)
I’m with you. No takes better care of me financially, than me. I’m not going to put my trust in a credit card company to cover me if a major disaster happens. I have a pretty large emergency fund (probably too large at this point) which gives me piece of mind. I also have a HELOC with a zero balance just in case. (It was a zero cost option)
Hazzard
1:43 pm (reply)
As a 22-year-old, the opportunity-cost issue is a major factor. I do have 6 months of living expenses in an account (barely beating inflation), but that money sure would be nice in my retirement account, considering how long it has to grow. 6 months of expenses now could become a lot of money over the course of 43 years…but I’m too much of a chicken not to have it saved.
2:03 pm (reply)
Like most of these decisions, it’s possible to play multiple hands.
I keep barely 3 months in penalty-free accounts, wagering that if I had to pay the penalties to withdraw funds from other accounts, they will have grown more than the paltry interest in my bank accounts. Since “emergencies” aren’t common, I’ve already made more than enough to compensate for any penalties (While I’ve had to tap into my 3 month fund from time to time, I’ve never had to tap into the 4-6 mo. fund in the ten years I’ve had it.).
I have a HELOC at the ready, too, and could opt to use that rather than pay the penalty, if the need arose.
3:04 pm (reply)
Assuming you are eligible, a Roth IRA can make a good backstop. Keep a couple months’s living expenses in savings, and in the face of a real emergency that exhausts this cushion you can draw on your credit cards or home equity in the short term. If the emergency becomes prolonged or overwhelmingly large, then you can always withdraw your Roth contributions without penalty. It is a last resort, but assuming it’s not your only retirement account (e.g. you have a 401(k) or pension) and have been contributing for a few years it shouldn’t be TOO painful.
9:50 pm (reply)
Good thoughts—the most effective way to have money available is to combine choices for a cocktail of a portfolio.
11:37 am (reply)
I don’t have an emergency fund because:
1. Our net worth is many times our annual expenses.
2. We have a lot of equity in our home, so we have a credit line at prime that can easily cover one year of expenses.
3. We are very disciplined to tap our credit line strictly for investment purposes or dire emergencies (No vacations charged to the credit line).
4. I can either earn taxable interest or pay off our mortgage (and indirectly save interest tax free). The spread is something like 4%.
I made two posts on this issue:
http://canadiancapitalist.blogspot.com/2005/09/emergency-funds.html
http://canadiancapitalist.blogspot.com/2005/03/are-emergency-funds-for-everyone.html
Some caveats:
1. The strategy may not be suitable for everyone even if they can afford to. Sleeping well at night is more important that earning a few more basis points in interest.
12:32 pm (reply)
Just last year I unexpectandly lost my job. Luckily I had an emergency fund for 3-4 months of expenses. Thinking back, I couldn’t imagine I’d want to tap into a HELOC not knowing when I would find another job. Knowing that you aren’t creating more debt while paying bills is a peace of mind I wouldn’t live without. I now have the efund built back!
4:03 pm (reply)
“emergency cocktail” ... I like it :)
seriously though this is what I’m aiming for…a smallish amount of cash to buffer the unexpected but not so much tied in cash that I am missing an opportunity to use cash to grow itself.
I guess i tend to think everything will be ok in the long run, so I”m willing to take some chances…I’ve been there and survived ;)
ex. I didnt technically use my HELOC for monthly expenses, but I did move about $5k of a 7% auto loan to my HELOC which was a bit over 4% at the time. which cut my monthly expenses by about $400. I paid (slightly) more than each month’s interest on the HELOC and the interst was deductible so it really helped us out (we had no emergency funds)
6:55 pm (reply)
Boss, good job recovering!
It’s good to hear that blogs are talking about havinig an emergency reserve now. I’m not sure what it will take to get people into action, though. The article mentioned here (I posted on this one also) really is an invitation to take the easy way out. Debt only goes so far. “Flexibility” in this article is a euphemism.
Instead, pay off the CCs and save the money! Don’t expect Uncle Sam or the kindness of strangers to bail you out.
3:29 am (reply)
6:47 pm (reply)
One could use EmigrantDirect.com’s 4% savings rate for some of that cash, better than the below-inflation-rate “savings” rates at most banks.