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.
Updated February 6, 2012 and originally published September 15, 2005.