Your Emergency Fund Strategy Could be a Waste of Money
Ask ten financial experts how much you should have tucked away in your emergency fund and you’ll likely get ten different answers ranging from $1000 to an entire year’s worth of living expenses.
However, what you do with your emergency fund may be just as important as it’s size.
The goal of the emergency fund is to have fast access to cash. A savings account is the investment vehicle that quickly comes to mind, as you can withdraw from it by walking into your bank or from an ATM.
Unfortunately, a savings account may not be a very wise place to store a large sum of money.
Take a look at a comparison of several options for placement of your emergency fund with respect to access, growth, and risk of return:
- Access: Immediate
- Growth: My bank currently offers 0.10% for balances between $2500 and $10000
- Risk: Low, balance is guaranteed, rate fluctuates slightly
- Access: Immediate
- Growth: My bank currently offers 0.20% for balances between $5000 and $10000
- Risk: Low, balances is guaranteed, rate fluctuates slightly
Whole Life Insurance:
- Access: 2-3 business days
- Growth: Average annual growth rate for my policy is about 5%
- Risk: Low, but the rate may fluctuate
- Access: Immediate to 3 business days
- Growth: Average annual growth since 1926 is 10.5%
- Risk: High, growth rate is extremely volatile and can even be negative
So what does this mean for the overall growth of your money? As an oversimplified example, let’s say a person could keep a steady emergency fund balance of $5000 and the interest rates mentioned above held constant. How would that money grow over 30 years given each of the above investment vehicles?
Savings Account: $5152
Money Market: $5308
Whole Life: $21,609
Stock Market: $99,963
Note that I also included a figure for inflation. Over the last 20 years, the average rate of inflation has been about 2.4 percent. Again, in an oversimplified example, that means that at the end of those same 30 years, you would need to have at least $10,185 to have the same amount of buying power that your original $5000 has today.
Putting your money into a savings account or money market actually costs you money!
As my wife and I start to concentrate on getting our emergency fund to where we want it to be, we’ve decided to take a tiered approach:
Tier 1: The vast majority of emergencies can be handled with $1000. This amount is also widely known as a “Baby Emergency Fund.” We want $1000 in a savings account that we can access at the snap of our fingers.
Tier 2: We want three months worth of expenses in a relatively stable account, but gives us a rate of return greater than inflation. We’re not locked in exactly where that is yet as there are many options that are not discussed here. However, something along the lines of our whole life insurance policy is our intended direction.
Tier 3: As we are still decades away from retirement, once we fulfill the first two tiers we will invest our money into longer term, higher risk, higher reward stocks.
To us this represents a balanced approach to having fast access cash, but also maximizing the growth of our hard earned money.
What is your emergency fund strategy?