This post is was originally published on Investor Junkie
Do you really need an emergency fund? After all, don’t consistent investing, rising markets, expanded investment technology and ready access to credit lines make traditional savings unnecessary and even counterproductive?
Let’s consider both sides of the debate and try to come to a logical conclusion.
The Common Arguments for Emergency Savings
Most of us know the usual reasons for having emergency savings. But since we’re debating whether or not they are actually needed, let’s review the most common arguments in favor of having one.
Ready cash for unexpected expenses. Sudden expenses are bound to arise. Having adequate emergency savings can keep these expenses from disrupting your budget. It can also prevent the need to turn to debt, particularly credit cards, to cover short-term, unexpected expenses.
Being prepared for an income disruption. The job market is not as secure as it was just a few years ago. Not only have job losses become fairly normal, but they often occur on short notice. An emergency fund can bridge the gap between when you receive your last paycheck and when your unemployment insurance benefits begin. That will help remove the financial shock the loss of a job can cause.
Avoiding the need to liquidate investments on short notice. If all of your money is tied up in either investments or retirement savings, you may be forced to liquidate positions in order to cover emergencies. This can force you to sell investments at the worst possible time. A well-stocked emergency fund can keep this from happening.
Keeping small problems from becoming big problems. Whether a problem is actually minor or a full-blown crisis is usually determined by the resources you have available to deal with it. For example, let’s say your car needs a $1,000 repair. If you have $10,000 in emergency savings, the repair will mostly be an annoyance. But if you have no liquid cash at all, it can turn into a disaster from the start. Emergency savings have a way of keeping problems under control.
The Common Arguments Against Emergency Savings
In recent years, particularly with the growth of investing and new investment products and applications, arguments have been made disputing the need for emergency savings.
Here are the more common reasons given:
You can always tap a credit line. Since credit has become so widely available in recent decades, there is a belief that unused credit lines can function as emergency savings. This is particularly prevalent since so many people have credit cards with available balances. This enables you to tap emergency cash only when it is needed and without having to have a reserve available for that purpose.
A Roth IRA can work as an emergency fund. Since contributions to a Roth IRA are not tax deductible, you can withdraw them at any time without having to pay regular income tax or an early withdrawal penalty. In this way, the Roth IRA functions as both a retirement plan and emergency savings.
The return on safe, liquid investments is poor. With the decline of interest rates over the past 34 years, the return on safe, liquid interest-bearing accounts has been admittedly poor. Accounts such as savings accounts, money market funds and short-term certificates of deposit (CDs) are well below 1% per year. Since that is a guaranteed money loser when you factor in inflation, the thinking is that emergency savings become a negative investment.
If you’re rich enough you don’t need emergency savings. The general thinking is that if you have a large enough asset base, emergency savings are unnecessary. The thought is that there is almost always an account somewhere that can be skimmed to cover short-term emergency cash needs.
Each of these points are at least somewhat valid. But let’s dare to consider the flaws in that thinking.
The Verdict: The Arguments Against Emergency Savings Miss the Mark
I’m personally in the camp of people who favor having emergency savings as a fundamental part of your overall financial plan. However, with the advent of the super bull market that has been in play since 1982, conventional conservatism has been in decline. There is a faction in the investment community that believes you should be 100% invested 100% of the time.
For that reason I believe the arguments against having emergency savings are mostly rationalizations to support that view.
Let’s consider how each of the common arguments against emergency savings miss the mark.
You can always tap a credit line. This argument has two major flaws. The first is that the whole concept of relying on credit lines to cover short-term cash emergencies is a recipe for indebtedness. That’s true at least in part because emergencies can arise with surprising consistency.
The second flaw is the prospect of credit freezes. We saw this happen during the financial meltdown, when banks froze credit limits on both credit cards and home equity lines of credit. It can happen again. Worse, the deteriorating economic conditions that cause credit freezes to happen usually coincide with an individual’s need for emergency cash.
A Roth IRA can work as an emergency fund. In theory, this sounds nice. The ultimate reality is that the primary purpose of a Roth IRA is to save money for your retirement. If you use the account as an ATM for short-term cash purposes, you run the risk of bleeding the account. This is exactly what happened with home equity lines of credit that were so common prior to 2007. Millions of people drained the equity out of their homes.
The other issue here is that a Roth IRA is an investment account. Because of tax deferral, holding cash in the account makes little sense. And if you do, you’ve really just created a tax sheltered emergency fund, which makes even less sense.
The return on safe, liquid investments is poor. This is the most legitimate argument against having emergency savings. But it also misses the point! Emergency savings are not supposed to be investments. They are supposed to represent idle cash that does little more than sit waiting for an emergency expense to cover.
Yes, it would be nice to earn a higher return on emergency savings, but that is no better than a secondary consideration. In addition, pursuing a higher return will likely require adding greater risk to the account. And that fundamentally changes the entire arrangement.
If you’re rich enough you don’t need emergency savings. This is another theory that sounds fundamentally logical. But once again, that doesn’t make it true either. Being rich is a matter of proportion. Yes, you may be rich by conventional standards, but rich often means bigger expenses and bigger emergencies.
Being rich doesn’t eliminate the need for emergency savings. Quite the opposite, in fact; it means you actually need to have even more emergency savings than other people do.
The Strongest Argument for Emergency Savings: Investment Insurance
Finally, here is the argument that swings the whole debate in favor of having emergency savings, no matter what. It’s avoiding the need to liquidate investments on short notice. It’s the third reason listed under “The Common Arguments for Emergency Savings” above, and it’s one every investor should be able to appreciate.
In order for your investment portfolio to grow, it must exist in something of a vacuum. That will enable it to grow consistently, without being raided for short-term cash needs. In order for that to happen, there needs to be a cash cushion that insulates your investments from financial disruptions. Emergency savings fill that role.
It doesn’t matter what your income level is or how large your investment portfolio might be. You need to have an account that will serve as the “moat” that separates your budget from your investment portfolio. Not only will that protect your investment portfolio from cash raids, but it will also be available to you even if the credit markets freeze up or there’s some other reason why borrowing is either unavailable or undesirable.
Are You a “Newbie Saver”?
If I’ve “scared you straight” today into wanting to start saving money, you should know that it’s not impossible or expensive. There are so many handy apps that can get you started with even mere pocket change!
Acorns is our favorite microsavings app. It lets you “round up” and save money from every purchase that you make with your checking account card.
You can check out all of our review of microsavings services here.
Do you think emergency savings have become obsolete? Or do you share my thinking that they are a fundamental part of a solid overall financial plan?