Most financial advisors will probably tell you to establish an emergency savings account. I personally am a fan of the emergency fund strategy, but it is different for every person, depending on what kinds of risks they have in their lives. I talk with my finance classes about different types of risk we are exposed to:
- Concentration risk
- Income risk
- Inflation risk
- Interest rate risk
- Liquidity risk
- Personal risk
Emergency savings can help with some of these risks, like a medical emergency or job loss, but they lose buying power to inflation, and they have an opportunity cost. The question is which of the risk factors above carries the most weight for you. If you work in a highly volatile industry, income risk may be a major concern. If you are a contracted teacher like me, maybe not so much. This is why it is important to “play devil’s advocate” and make arguments against conventional wisdom in finance. Let’s examine the argument against establishing the infamous emergency savings account.
Greg McFarlane of Investopedia makes some great points in his article today, “Why Emergency Funds Are a Bad Idea.” He addresses the major opportunity cost of emergency savings for many American families: the average household credit card debt in 2016 was $16,748. Yes, you read that correctly: $16,748 in credit card debt. That is a massive amount of high-interest-rate debt that is compounding. It should be a lot more concerning than a future problem that may or may not actually happen.
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.
I have been conflicted throughout my life about whether to pay off debt or save and invest. Learning how to calculate simple and compound interest comparisons has helped me solve some of these problems, but I don’t think you ever eliminate this conflict 100%. Every individual and every business debate this issue on an almost daily basis.
For example, I recently charged a $2,000 dental bill to my credit card because I have no interest on the card until November. However, the prospect of allowing any of that balance to be exposed to compounding interest is terrifying, so I really need to get it paid off by November. I also have student loan debt to consider. A few of my loans’ interest rates just went up to 10%, so I would really like to pay them off faster. On the other hand, I do not want to stop making contributions to my investments, especially in this profitable bull market.
For these and other reasons, I have reduced my emergency savings account from $3,000 to $1,000. My debt is a real problem that is here right now. It is a lot more concerning right now than potential future costs. I feel like I have to have some amount of cash on hand for liquidity’s sake, and $1,000 really isn’t that much. However, I only have the luxury of making this liquidity argument because the credit card balance is not subject to interest yet. If it comes down to November and I haven’t paid it off, I will empty the savings account into the credit card before any interest kicks in.
McFarlane is right. Paying off a revolving debt account subject to double-digit-APR compounding interest is a lot more important than saving cash for a return of less than 1% interest. Sometimes the conventional wisdom is flawed, which is why it is important in personal finance to understand basic economic concepts like opportunity cost, rather than simply abide by the hard-and-fast rules of financial advisors.
Update – May 24, 2017
Amy Fontinelle posted an Investopedia article this morning suggesting ways to earn a higher interest rate return on your emergency savings account. She has some great ideas that could be helpful to someone who wants to have emergency savings but hates the idea of losing so much value to inflation.