Overfunded Emergency Funds
There is some bizarre savings account/”emergency fund” fetish in personal finance literature. There’s also a parallel fetish for high interest rates on these accounts. Emergency funds, like all insurance, are pretty terrible sinks of resources when things go right. They should only be used as much as necessary.
So what is necessary?
There is a standard of six months salary used by many. I find this to be quite stupid for a number of reasons. First of all, salary doesn’t have anything to do with your expenses. How about we start with six months of expenses. If those two numbers are the same, then you’re not saving any money anyway, so you can quit calculating now. But yeah, let’s say your expenses include saving 20% of your salary, don’t you think that you could probably cut back on that while you’re unemployed? We can take this even further, does this include some sort of budget for vacations or fancy dinners or other, unnecessary things? I need to pay for my mortgage, my insurances policies, utilities, toiletries, and food. If I lost my income tomorrow, that food expense would get a lot cheaper. The utilities could be made cheaper, but I don’t want to have to do that so I’ll keep some money saved for that too. These things are far from including everything I spend and save, but they are the things that I’d be unable or unwilling to give up in the event of an emergency.
But we’re still no where near done tuning this standard. Do you have credit card debt? If so, you’re emergency fund should be way smaller. The highest savings account that I know of right now is 1.6% APY. Your credit card is probably between 7% and 20%+. What are you doing saving money at 1.6 and then borrowing at over 7? Figure out what you need to pay your minimums for however many months and then save that and nothing more. Every other cent should be put into paying off these credit cards. If all goes well, you pay them off much quicker and for much less money. If all goes as bad as planned for, you quit paying off the credit cards when you lose your income, you use the credit cards to get by, and you pay the minimum using your emergency fund. This is exactly the same result you would have had if you would have saved in the emergency fund instead of paying the credit cards off. That’s right, the worst case scenario is as bad as the thing that you’re deliberately doing if you prioritize the emergency fund over paying off your debt.
Last, where the heck did six months come from? I have known almost no one to be layed off for six months. During the recession and recovery, I saw people out of work for years. I’ve known a lot of people to lose their jobs and then shop around for as long as they could for another one which meant a few weeks to just shy of a year. This shouldn’t take long to do; take a quick look at yourself, your location, your industry. If you lose your job today, how long until you get another? Are you a factory worker in a one factory town? Are you a minimum wage worker in a fast grown metropolis? This thumb-rule of six months would be good if it took a really long analysis to figure out your employment prospects, but it doesn’t.
And as for those interest rates on your savings account. Remember, small differences in rates only matter if the interest is compounded. If you need $10K in your savings account, and at the end of the year, you made $100 in interest instead of $50, that’s kind of cool. But it ends there, because if you need $10K the following year, take that interest out and put it somewhere where it’ll earn some real money.
I’m not saying that $50 doesn’t matter, I’m just saying that this is something to get good enough once. You should not be going through the hassle of opening a new account every week. Find one that is convenient enough and an acceptable rate and call it good.
