First things first. What’s a rainy day emergency fund? It’s simply some money you’ve set aside just in case of an unexpected situation where money can help, such as a job layoff, needed medical treatment, or bail (it happens!).
And really, can’t most negative and unforeseen events benefit from a bit of money? It’s rare you would hear, “I’m sorry, I have a real problem on my hands here and I’d really appreciate it if you’d stop trying to give me money.”
No, most of the time, money is exactly what is needed to at least temporarily solve the problem or better the situation. Sometimes, we need to get out of a jam, and money can help. If you lose your job, it’s nice to have a cushion to pay the rent and buy food. It’s important to have the ability to pay high medical deductibles if you get hurt or sick. If you get a flat tire on the way to work, you need to be able to get it fixed and get back on the road. Stuff happens, and money can certainly help in an emergency by providing options and getting the help you need.
So you definitely need an emergency fund, and most experts say you should have six to 12 months of living expenses in cash. What does this mean? Basically, you would make a list of your essential living expenses, such as rent, insurance, etc. Total just the essentials, and the goal is to have several months of cash available to cover these.
But actually, that’s not the goal. In fact, and this is where I’ll probably get into trouble. Most financial experts are wrong.
The financial planner police (yes, they exist!) might kick me out of the industry if I suggested it was not important to have the ability to cover these emergency situations. But the antiquated six to 12 months in a checking account or money market account is a terrible idea.
Consider a 30-year-old couple. They’re doing their best to save for retirement and raise a family. They calculate that 12 months of living expenses is $75,000. Like good students, they follow the standard financial advice and set aside $75,000 in a savings account at a bank. After a few high fives, they go on about their lives feeling good about their “smart” financial decision. It’s too bad, though – they just cost themselves $1 million.
Here’s the math:
Traditional Emergency Reserve
- $75,000 in savings account
- 1% interest rate
- 35 years (until age 65) TOTAL: $106,245 Difference: $1,002,655
Alternative Emergency Reserve
- $75,000 in diversified investment portfolio
- 8% investment return 35 years (until age 65) TOTAL: $1,108,900
The difference between the emergency reserve savings account and the alternative account is a whopping $1 million!
The “alternative emergency reserve” is simply to invest the cash in a diversified investment portfolio. “But hold on,” you say. “Where’s the rainy day fund when you need access to money quickly?” You absolutely should have access to assets, cash, or some way to cover these emergencies, but there are many other sources you could access that won’t cost you a $1 million at retirement. Here are just a few:
Home equity line. If you own a home, apply for a home equity line of credit. If approved, you will get a checkbook from which you can write checks if you have an emergency.
401(k) loan. Check with your employer to see if your 401(k) allows for loans. You can withdraw 50% of your balance up to a maximum of $50,000, or if your 401(k) balance is $10,000 or less, you can borrow the full amount. You should avoid borrowing from your 401(k) and only consider it as a last resort.
Credit cards. This is often the quickest way to access cash or pay for an emergency – often even faster and more convenient than with- drawing cash from a traditional emergency reserve account.
Investment account. As long as you don’t have illiquid investments, the $75,000 you invest can be accessed within a day or two at most.
The takeaway isn’t that having an emergency reserve is a bad idea – it’s imperative that you have access to a source of funds that you can tap into quickly. The takeaway is that if you keep your emergency reserve assets in cash, a savings account, or money market, you get so little interest or return on this money. I call this a dead asset.
Instead, make sure you have access to assets if there is an emergency. Maybe set aside a few thousand in cash, but take the rest you would have set aside and invest it. Over time, and in this case, 35 years, there is a good chance you’ll do a lot better than if it just sat in your checking account.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.