Why An Emergency Fund Is A Great Investment

Of all the recommendations I make, the one that seems easiest for people to pooh-pooh away is keeping enough emergency savings. I get it, it’s not sexy like investing or paying off your mortgage early(or flying to Europe?), but if you ignore your emergency savings you put your financial well-being at greater risk and actually cost yourself money. Two recent surveys revealed that 34% of Americans have no emergency savings at all and that 69% have less than $1,000 saved. So chances are if you’re an American, you don’t have much in the way of emergency savings. Here are four reasons you should make your emergency fund a priority.

1. Keeps you out of debt(or from getting deeper into it).

Having cash on hand for handling unexpected emergencies saves you from reaching for the credit card or taking out personal loans. A lot of people tell me that’s exactly why they keep an emergency credit card at home that they never use (wink, wink) unless it’s an emergency. Here’s a good question to ask, if you can’t afford to set aside money for emergency savings, how do you expect to afford to pay off the credit card, plus interest when something does come up? It’s tough enough to pay off the debts of a relatively small emergency, let alone a major one like six months without work.

2. Cuts your expenses.

Wouldn’t I get a better return on my money by investing it instead of keeping it in a boring bank account for emergencies? Well that’s possible, but having easy access to cash for an emergency can make up for those lost (potential) investment returns. When you have emergency savings you can lighten your dependence on insurance policies to protect you. While you shouldn’t keep enough cash in emergency savings to totally eliminate all of your insurance policies, having savings set aside will mean you’ll have no problem paying a higher deductible if you  do need to depend on insurance. For example instead of having a $100 deductible on you car insurance, with enough savings, you could switch that deductible to $1,000 and pocket about $600 per year on cheaper insurance premiums. Hows that for a return on investment? Consider those savings over multiple insurance policies and you’ll be looking at some serious money over time(maybe enough to do something sexy like cruise around the world?)

3. Protects your long term financial plan.

Unexpectedly losing a job, going onto disability, or surprise medical bills can all throw a wrench into your long term financial plan. Even if you’ve been doing a good job at putting money into your retirement accounts, have the right insurance in place, and are paying off debt with more than minimum monthly payments, all that could get derailed in a matter of months without the right emergency savings. Pulling six months of expenses from your 401(k) would be an incredibly damaging hit to your long term goals. Most people should expect to lose 30-40% of any retirement savings they pull out for emergency expenses due to Federal and State income taxes and penalties. Ouch. Not only is that a lot of short term pain to deal with, it will also be very difficult to catch your retirement accounts back up.

4. Improves your mental health.

Having the right amount of emergency funds set aside has the less tangible effect of helping you feel more secure. Knowing that surprise expenses are covered gives people a sense of strength and a feeling of near invincibility. This lowers stress and increases personal confidence, both extremely valuable factors.

So how much should you set aside?

Of course, like everything, this depends on your situation, but for most people the long term target is to have six to twelve months of living expenses set aside as emergency savings.  If you are self-employed or own a business, you may want to have six to 18 months set aside. Also consider a more substantial emergency fund if your income is not steady, your industry is prone to layoffs, or we are in a recession with higher than usual unemployment rates. A common axiom by financial experts is to suggest three to six months of living expenses for an emergency fund, but renowned expert Suze Orman refutes that by saying people need to set aside enough to know that they are going to be financially secure and suggests that in order to do that people need eight to twelve months worth of expenses set aside.

What if you can’t afford to save?

Start with whatever you can and setup a direct deposit from your paycheck so you don’t even notice it missing. Even $5-$10  week can eventually establish a small safety net. If you’re currently paying off credit card debt, don’t try to establish a three month emergency fund right off the bat. Credit card interest rates are just too expensive not to attack aggressively. Instead establish a small emergency fund from $500-$2,500 depending on your situation. Having this small emergency fund will keep you from going backwards while paying down debt and mysteriously seem to reduce the number of things that do go wrong. Try to keep your emergency savings somewhere you won’t see it on a regular basis like an account at a separate bank.