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Last week, I came across a post by Greg McFarlane over at Investopedia called, Why Emergency Funds Are a Bad Idea. And before I weigh in on the crux of his argument, I thought I’d review my emergency fund experience.
My Emergency Fund Experience
First off, Mrs. Groovy and I got very lucky when it came to building our emergency fund. In 2006, we sold our New York condo at the height of the real estate boom and made enough money to buy a house outright and establish a two-year emergency fund when we relocated to North Carolina. So for 11 years now, we’ve had basically $60K sitting in a Bank of America savings account earning squat.
And how many emergencies have we had during these past 11 years? Five. Here they are.
1. When we first moved down to North Carolina, we decided to dabble in real estate and bought a rental property. In 2010, the HVAC system in our rental finally crashed—in the middle of a blistering summer, no less—and we needed to replace it. That costed us $3,800.
2. In 2012, the power steering rack on the Camry went. That cost us $1,200.
3. In February of 2016, Grandma Groovy died and we needed to fly to Boston on short notice: $1,100.
4. In July of 2016, lightning took out our garage door opener: $350.
5. And, finally, in September of 2016, Cousin Groovy died and we needed to chip in for his cremation: $500.
There may have been other emergencies that I missed. But if I did, they didn’t cost much money. Let’s now see why Mr. McFarlane is so against the vaunted emergency fund.
McFarlane’s Case Against the Emergency Fund
First, to make his case against the emergency fund, McFarlane takes the US per capita income of $55,836 in 2015 and assumes an effective tax rate of 20%. This would give the per capita American a disposable income of $44,669.
Next, McFarlane deducts a personal savings rate of 5.3% from the $44,669 to determine the per capita American’s annual living expenses. This number comes to $42,301.
With monthly living expenses of roughly $3,525, then, the per capita American would need the following amounts for the emergency fund sizes recommended by personal finance gurus.
Recommended Emergency Fund Based on Monthly Living Expenses of $3,525
| Size | Amount |
|---|---|
| Three Months | $10,575 |
| Six Months | $21,150 |
| Nine Months | $31,725 |
| Twelve Months | $42,300 |
Okay, with all these preliminary figures in mind, McFarlane goes in for the kill.
If [these emergency fund] numbers sound high, or even if they don’t, understand that in the U.S. the average household credit card debt was $16,048 in March, 2016. Americans are also carrying a cumulative $1.32 trillion in student loan debt, which dwarfs the credit-card debt on a per-borrower basis.
Then he delivers the coup de grâce.
In other words, the math doesn’t come close to working out on emergency funds. 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%.”
And, finally, he offers his prescription.
Take the money you’d otherwise devote to an emergency fund, 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.
Is McFarlane Right?
Providing your insurances are all lined up, as McFarlane also stresses, I think he has a valid point. It’s probably better to pay off all of your consumer debt before you start an emergency fund, and it’s probably better to put whatever emergency fund you do establish into a bond fund so it can earn a two percent return.
But then again, my emergency fund experience may be atypical. Mrs. Groovy and I haven’t been hit by any killer expenses out of the blue. My father, on the other hand, had to spend $16K a few years ago for a four-month supply of a blood-clot medicine that wasn’t covered by Medicare. What if either Mrs. Groovy or I had a similar setback? What if one or both of us had lost a job? And what if we had kids and all the unexpected costs they thrust upon a family? Would we have viewed our emergency fund under those circumstances as a “staggeringly inefficient use of [our] precious and limited resource[s]”?
Damn! No one ever said blogging about personal finance was going to be easy. In light of Mr. McFarlane’s convincing anti-emergency fund arguments, I have modified my stance on emergency funds. Here are my new guidelines.
- While you’re paying off your consumer debt, keep $1,000 in a savings account as an emergency fund (King Dave is right on this point).
- Once you’ve paid off all of your consumer debt, keep no more than $5,000 in a savings account as an emergency fund. Five thousand dollars should cover 90 percent of the emergencies you come across.
- Do what McFarlane suggests. Put whatever additional emergency fund money you need for a good night’s sleep into a CD or a bond fund. A two or three percent return is better than nothing.
Final Thoughts
Okay, groovy freedomists, that’s all I got. What are your experiences with an emergency fund? How many months of expenses do you have sitting in a savings account losing value? And how many times have you actually used your emergency fund over the past five or ten years? Do you find the standard advice on emergency funds to be overkill? I’d love to hear what you have to say. Peace.
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