The common advice to create an emergency fund is overly prudent. For many people, what is more important is to have an objective understanding of risk to realize that there are far better places to put your money than an inert account that can’t enrich you.
The most recognizable personal finance mavens are almost unanimous in their advocacy of the emergency fund as a vital part of any common-sense financial plan.
Their recommendations differ only on size—three months, six months, perhaps eight months of living expenses are enough to accommodate whatever misfortune might befall you. But to what end? And do people really listen?
- It's prudent financial advice to accumulate an emergency savings fund that can last for a few months if necessary.
- For many people, however, being a diligent saver means forgoing paying for other things including obligations and debts.
- Make sure to do the math before saving for emergencies so that other financial priorities are not left behind.
Why Emergency Funds Are A Bad Idea
Do the Math
First of all, exactly how much money are we talking about here?
In the most recent statistics, the median household income in the United States was $63,179 in 2018 according to the most recent data from the U.S. Census Bureau, and the personal savings rate of disposable income has been around 8% since 2018, according to the Bureau of Economic Analysis.
Using the conservative recommendation to sock away eight months’ worth of living expenses for your emergency fund, that means it’d take almost $42,500 to create a sufficiently stocked emergency fund, and that's before taxes are taken out of your income.
Even using three months of emergency savings, you’d still need $16,000 for an emergency fund that passes the muster of convention. To put that in perspective, the U.S. average household credit card debt was just over $6,000 in 2019 according to data from Experian. Americans are also carrying a cumulative $1.51 trillion in student loan debt, as of the end of 2019, which dwarfs the credit-card debt on a per-borrower basis.
The point is that adding to emergency savings means you can't spend on other needs and wants or pay down debt. If the experts are going to issue a blanket recommendation to millions of people that they should all create a buffer to tie them over in unforeseen circumstances, it would make far more sense to say, “Instead of amassing an account that pays you 0%, or a few basis points above that, maybe you should focus on closing out an account or two that’s costing you 15%.”
Clear Debt First
It’s easy to insist that emergency funds are crucial for everyone while ignoring just what position the average household’s finances are in. If you’re carrying credit card debt, student loan debt, or both, then building cash reserves for anything other than paying down those debts should be the last thing on your mind.
Of course, the more economically you live and the more money you make, the better positioned you are to create an emergency fund. But this is where the irony lies. Because, as a rule, the folks who are diligent enough to live without consumer debt usually pay their bills on time. They do not impoverish themselves so they or their offspring can attend college, and they do not spend extravagantly. They are also the ones who are going to be least prone to emergencies, and thus least in need of an emergency fund.
Perhaps you’re worried about the transmission falling out of your car, which you think would necessitate a $3,000 repair. If you feel that the prospect of this problem warrants creating an emergency fund, but you’re already carrying enough debt to cover three or four transmission replacements, the sad news is this: your emergency has already begun. It began several thousand dollars ago.
If you’re going to minimize risk for yourself or your family—a noble task in and of itself—society has already developed several methods for doing so, any of which you can use to your advantage. We have health insurance for that (just make sure to have enough for your deductibles).
Not only will a comprehensive health plan cost less than a regulation emergency fund, but the former is also earmarked for a specific purpose. The same goes for the fear, however irrational, of a cataclysmic car accident. Again, we have auto insurance. If you’re really that concerned about worst-case scenarios, spending a few dollars raising your coverage limits to the maximum makes far more sense than does spending thousands more on an emergency fund.
But What If I Lose My Job?
If you do, there’s this thing called unemployment insurance. Your employers pay into it, and it's for your benefit. We also have a workforce in which (overall, if not in every individual case) approximately 96% of those who want jobs have had them—at least until the pandemic hit. Chronic unemployment, or underemployment, is not the province of that class of people who have the wherewithal to defer spending long enough to save up several months’ of living expenses.
There is a caveat: If your work does not provide a W-2, you may not be covered by unemployment insurance, except for the pandemic period in which you may qualify for Pandemic Unemployment Assistance (PUA), which extended coverage to gig workers and other categories usually left out of unemployment coverage. It's worth checking whether you qualify. It's also a reminder that real emergencies can happen even to the most prudent individuals.
One prominent financial authority, Dave Ramsey, once even cited “unexpected pregnancy” as a reason to build an emergency fund, leaving open the question of whether there exists anyone on the planet who is simultaneously a) responsible enough to set aside six months’ of living expenses, and b) not so responsible that they don’t know how to prevent pregnancy.
If you’ve already built an emergency fund, you may wonder whether you should dip into it to do the following:
- Buy a plane ticket to interview for a promising new job
- Replace your dying car with something more reliable
- Remove your old carpet that’s shredding to bits and lay over the underlayment with tile
But understand that those aren't emergencies. Those are merely life.
The Bottom Line
Should you be among the subset of the population that enjoys positive net worth and has taken steps to reduce the possibility of being impacted by an emergency, congratulations. But understand that that’s all the more reason not to create an emergency fund—at least not the classic kind. Because an emergency fund is supposed to be easily accessible and liquid, the recommended vehicle for it is usually a savings account. Savings accounts don’t even keep pace with inflation, meaning that an emergency fund is a money-losing proposition over the long term.
Take the money you’d otherwise devote to an emergency fund and put it in something even as humble as a short-term certificate of deposit (CD)—that should give you FDIC protection. You can also pick a higher-risk blue-chip stock or bond fund—which adds to your risk, but gives you instant access to your funds if you need them.
Either way, you’d be building wealth instead of watching it methodically diminish. Taking the time to build an emergency fund, and forgoing consumption for months while doing so, is a staggeringly inefficient use of the precious and limited resource that is your money.