Is Building an Emergency Fund Always a Good Idea?


The Great Recession of 2007 drove home the common-sense notion of being prepared. Specifically, it gave a lot of traction to the idea of having a 6-8 month emergency fund. Today, nearly every financial advisor parrots the same call — everyone everywhere should have months and months of living expenses socked away in an easily accessible account.

But is building an emergency fund always a good idea? And does the wisdom behind the advice translate to every financial situation? I don't think so. (See also: Put Off Saving for Retirement)

At the risk of sounding heretical, I humbly assert that every financial circumstance is unique and creating a hefty, low-interest, immediately-accessible emergency fund might not be the smartest way to manage your money. Here are a few situations where it just might be okay to skip scrimping and saving to build an emergency fund.

You Have High-Interest Consumer Debt

Unlike an emergency, your creditors are a sure thing. If you have credit card debt, those high interest rates will be applied month in and month out. But the interest you'll get from a bank on a savings account is something akin to not-worth-mentioning. Get more bang for your buck by paying off your credit cards first.

You Have No Retirement Savings

If you're young and trying to decide between funding a Roth IRA or 401(k) account and putting money away in case of emergency, bank on your retirement. The time horizon is long enough that you'll see real growth from compounding interest. Plus, with 401(k)'s company match and Roth IRA's tax-free growth, both types of savings vehicles can be powerful wealth producers over the long term.

You Have No Debt and Low Expenses

On the other side of the coin, if you have no debt and very low expenses, an emergency fund may not be the critical lifeline for you that it is for others. In an emergency, low overhead works in your favor and modest financial obligations can be met in a variety of ways besides a savings "super-fund." Redirect that cash toward investments that offer better long term returns.

You Have Investments That Are Accessed Easily and Without Penalty

Panicked about not having money saved for the what-ifs in life? Relax — maybe you already have an emergency fund and just don't realize it. Investment dollars that you can withdraw without penalty achieve the same goal (and may be earning a higher interest rate in the meantime).

You Have Flexible Finances

If you're financially flexible and can easily contract in the event of a temporary layoff or unforeseen income hiccup, maybe an emergency fund isn't an absolute essential. Having some serious wiggle room financially has some real rewards — and not needing a huge emergency fund is one of them.

None of this advice is meant to suggest that preparation is a bad idea. Being financially alert helps us survive, thrive, and seize amazing deals when they come our way. But bloated emergency funds, built only by ignoring other wealth producing opportunities and applied in one-size-fits-all fashion just don't make sense. In other words, sometimes the best preparation is knowing what we don't need to prepare for.

Do you have an emergency fund? Is your fund in a traditional savings account or another type of investment?

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Guest's picture

I have an emergency fund but it is not so much set up to be one. Growing up, I had a weird obsession with investments. My neighbor and I would pull the stock quotes from the newspaper and look through to see how much each was up or down as if we could call up a stock broker and tell them to sell! sell! sell! When I would get a bond or inheritance from a family member, I would invest it. It was never much money but over the years (and even with the economy) I have been able to make some money which is now in a mutual fund. I can pull the money when I need it and other than that i have no reason to touch it. It is reassuring to me that I could live off of that money for a few months with out panic.

Guest's picture
Concerned Citizen

From personal experience, this is horrible advice. Besides, you say one thing and mean the other. Since when does an emergency fund have to mean "no interest earned" (my words, not yours) on your money. There are fantastic ways to save money and designate it an "emergency fund". I've found that always saving is preferential to not and paying all to creditors. It leaves you with nothing when you reach the end of paying your debts. And using a vehicle like a Roth IRA does give you the advantage to pull out principle invested without a tax penalty, but raiding your funds for retirement is never a good thing if you can avoid it though other means.

Kentin Waits's picture

I think point #4 speaks to that very case -- money that can be used as an emergency fund, yet is still earning decent interest. Typically though, emergency funds are kept separate from a person's regular investment vehicles (following the 'make sure it's always-accessible' mantra) and, therefore, earns very little interest. Not always the case, but often. Thanks for your comment.

Guest's picture

While I agree with you that a Roth IRA is a good alternative to the traditional "emergency fund", somehow I still believe that an emergency fund should be readily available, even if I don't earn any interest.

Let's say it's Friday afternoon and you need to use that emergency fund. With the Roth IRA, I need to wait until Monday morning to liquidate my investments, then wait three days for the funds to settle (although you could pay a small fee to do a prepay), then complete the withdraw process, which will take additional time.

An emergency fund is just a small amount of money, 3 months or 6 months worth of your pay (I understand that can be sizable if you have a high income, but that also means you have bigger investments somewhere else). It's ok to leave it in cash and have it readily available in my opinion.

Guest's picture
David Kuck

I like at least part of Dave Ramsey's approach here. He suggests starting with a $1000 "baby emergency fund" to make sure you don't go back into debt on an unexpected repair bill or accident. After you have the $1k set aside, THEN pay off your debts is what he recommends.

Guest's picture

I have a stable job, so I often build up a three-month emergency fund and then periodically deplete it for investment opportunities, etc. It is hard to watch it sit in a savings account with next to no interest being earned (though perhaps I need to find ways to better store, as you indicate in your fourth point). Once I use it, I begin to build it again and then I repeat this cycle periodically.

Guest's picture

Am I being to aggressive because as I see it my emergency fund is going to take forever to save up. I figure if I live bare bones I can get by on $2,000. I can probably do $1500 if I eat ramen noodles everyday, and cut off internet and cable. But really, my monthly expense are $1500 easily without splurging, so we might as well use 2,000. I'm self-employed, so I am more comfortable saving up six months living expenses at this point. Three doesn't seem like enough. I'm bringing in about $4,000 a month. I figure I can comfortably put 400 a month into an emergency fund. At that rate it will take me 30 months to build up a six month emergency fund. Does that sound right, or am I saving too much? 400 x 30 is $12,000 which is six months for me. OMG!!

Guest's picture

I agree with the first point to an extent. Paying off high interest debt is the best way to improve cash flow, but why did most people in this current economy used a credit card?

To buy the necessities like food, pay for utilities, and other important living expenses. A family with an emergency fund prevents a family from relying on debt to pay for the basics.

Guest's picture

To me "High-Interest Consumer Debt" *is* the emergency! Once that's 100% gone, it would be incredibly stupid not to have a fund set aside, even if it's just earning minimal interest. Sure, you can live in Tornado Alley, not have insurance, and never get hit, but it doesn't make you clever.

Otherwise, I think this is simply a Devil's advocate stance just to create an attention-grabbing headline. [Sigh]... The things people will do for ratings.

Guest's picture
David M., CFP®

There are some very good reasons why you should have a proper emergency fund. Here are a few:
1. Job loss- If you are out of work (especially in the case of singles) you may run up sizable credit card debt trying to cover expenses. Even if you qualify for unemployment, it is not going to cover your living expenses and it may take you longer than you think to find another job.
2. Deductibles- You need to be able to cover deductible like car insurance, homeowners or renters insurance, disability elimination periods, and health insurance when you are hit with unexpected situations.
3. Health Insurance premiums after loss of job- You may be able to continue your current coverage because of COBRA; but you will be paying a lot more than the premiums you were used to.
4. Buffer long term investments- You may do a great job of putting money away into that mutual fund or IRA; but as many found out in 2008-2009, if you need to get to emergency savings and have to sell that mutual fund or liquidate part of an IRA, you may be selling in a down market. In the case of an IRA, you may be paying income tax and early withdrawal penalties too.

There is a reason it's called an emergency fund. Its purpose is to help you get through life's unexpected events. You don't worry about what interest rate you are getting on an emergency fund because liquidity and safety are the most important investment objectives with it. You do your more growth oriented investing in your retirement and long term investment accounts. Always separate your short term money from your long term money. You'll be glad you did.

Guest's picture

Six months of living expense is quite a lot to have lying around doing not much. If one owns a house and has some equity in it, what do you think about establishing a home equity line of credit (HELOC) to cover an emergency that is greater than say just one or two months of living expenses?

Guest's picture
David M., CFP®

Ferrel- Yes, it does seem inefficient to have that much money in a low yielding investment; but these days that amount can disappear in a hurry under the wrong circumstances. The reason the HELOC is not a good idea is two fold; 1. A HELOC is secured debt. You would be taking out debt for living expenses against the value of your home. If your circumstances didn't get any better soon or worse, continued to deteriorate, you could be putting your home in danger. 2. During the downturn of 2008-2009; the credit markets froze up. Many people had unused lines of credit shut off. They could not access a HELOC even if they wanted to. Remember, just because you have equity doesn't mean the bank has to lend additional money to you. Before 2008, I encountered many advisers that wrongly gave out the same advice and put their clients bad positions. I would never recommend that strategy to one of my clients.

Guest's picture

I agree that whether or not to build an emergency fund depends on individual circumstances. That said, after I paid of credit card debt and student loans a couple years ago, I only had my mortgage debt left. At that point, I began aggressively saving an emergency fund. And good thing, because I ended up quitting my lucrative but exceedingly stressful corporate job a few months ago. I only had the option because I had the emergency $ to fall back on.

Guest's picture
David M., CFP®

Bingo CGK! Good example. We sometimes underestimate the usefulness of an emergency fund. Liquidity and safety are the two most important objectives when considering investments for an emergency fund.

Guest's picture

I think you should always have some liquid savings to fall back on in case of job loss (voluntary or otherwise). It has to be a number you are comfortable with. For me that number is $10,000, for other people it may be more or less depending. It gives you options to do what you want, like leaving a stressful job. But I think the point of this article is not to overdo it and invest too much in an emergency fund to the point you miss out on other investment opportunities.

Guest's picture

We are slowly building an emergency fund, but the money sits in an offset account on our mortgage, so not only are we prepared in case of emergency, but we are saving interest every single day while it is there.

One nice thing about the mortgage is that the interest rate is always higher than a savings account, so whilst we might earn 4% in a 'high interest' savings account (ING or similar) we save 5.5% interest by leaving the money in the mortgage offset account. We don't see the money, but the debt goes faster.

Sure we could make more money using the fund for stocks or similar, but that introduces risk, and for an emergency fund, it should be low risk.

Guest's picture

Why is your mortgage at 5.5%. Have you explored refinancing?

Guest's picture

I firmly believe in the concept of an emergency fund and I believe everyone should have at least three months of gross (yes, gross, not net) income saved up.

However, the only thing I disagree with is the idea of keeping it in a low interest savings account for safety. I agree that doing something risky with the money is not a good idea, but at the very least, I think it should be invested in an bond index or just Treasury bonds. Basically, *something* that doesn't make you feel like you hid the money under a pillow.

Guest's picture
David M., CFP®

Your point is well taken; however, I would still caution people to tread lightly here. Bond funds, like a bond index and Treasury Bond fund, hold portfolios that have long effective average duration. Effective duration gives you a good idea of how the value of the fund will change based on a change in market interest rates. The value of a fund that has an average effective duration of 3, will have a plus or minus 3% change in it's value for a 1% change in interest rates. Vanguard's Bond Total Bond Index currently has a 5.3 effective duration. If interest rates go up 1%, the value of the fund will fall about 5%. You can see how, with interest rates at historical lows right now, your emergency fund could lose over 5% of it's value in a rapidly increasing interest rate environment. IF you insisted on non-FDIC investments, I would recommend an ultra-short or short term bond fund instead. I still prefer bank money markets and CD's; however, because in an environment similar to 2008, when credit markets freeze up, it could negatively affect the liquidity of your mutual fund. It is always better to match your investment with the potential time frame that you would use them. You wouldn't buy a 10 year Treasury Bond for your emergency fund, even though the interest rate is much higher than a one year CD, because of the possibility of having to sell the bond on the market at a loss because you needed the money quickly.

Guest's picture

I think the last point -- flexible finances -- is an important one. Many people say an e-fund should consist of 3-6 months of living expenses, but one objection I've always held to that idea is that if you lose your job, your discretionary living expenses will (or should) go down. You'll still have to pay your mortgage, yes, but you probably won't go to restaurants, buy clothes, etc. Perhaps it should be amended to 3-6 mo. of "necessary" living expenses.

Guest's picture

This is really helpful information!

I currently have a 6-month emergency fund, but I fall into the "no debt and low expenses" category, so 6 months for me is only $10,000 ($1600x6=$9600, rounded up).

Yes, $1600 is not a whole lot to live on, and in good months I do spend more than $1600 from various other funds (allowance fund for high-ticket shopping items, or occasionally I go over my grocery budget by buying all organic foods from the farmers market, or go out to nice dinners with friends, for example). I know that there have been months where I've stuck to my $1600 baseline, and if I hit a rough patch I could go back to the basics in a snap.

Also, I'm 25 and if I needed to, I could move back in with my parents temporarily and cut my expenses to $600 per month, which would make my 6-month fund stretch to cover up to 16 months of living expenses in that situation! Or I could move abroad (back to Spain, where I lived before, for example) and easily cut my living expenses to $1000 per month and have the adventure of a lifetime.

I was recently thinking about increasing my 6-month fund to a 12-month fund just for more peace of mind, since I earn a variable income and things are slowing down for me, I may be jobless soon.

But then after reading this I realized a few things:

1. I have a "travel fund" that could easily cover a few more months of living/travelling abroad
2. I have an investment account that is earmarked for "future business/education" (in the event i decide to start a business that requires start-up cash, or go back to school) that is equal to at least another 6-month fund, and I can withdraw it without penalty.
3. Worst case, I can also withdraw from my Roth IRA in a true emergency.
4. I have other accounts in ING Direct such as "Allowance," "Emergency" etc. that can be used too.
5. I have no debt and can cut my expenses (mentioned above)

MOST IMPORTANT, I truly believe I could find another way to EARN MORE MONEY, even if it's less than I make more.

When I quit my stable job earlier this year and thought I would use my 6-month fund to live, I ended up finding a job within 3 weeks (after travelling abroad for 3 weeks).

If I hadn't found a job that fast, I could have done temp jobs, freelancing, etc.

So I think this is good additional emergency funds for me, I'll focus on maximizing my investments and earning more!

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