Your Emergency Fund Strategy Could be a Waste of Money

Today’s guest post comes from Brock from CleverDude where he shares his insights on family, life, and finances.  You can also follow Brock on Twitter.

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:

Savings Account:

  • Access:   Immediate
  • Growth:   My bank currently offers 0.10% for balances between $2500 and $10000
  • Risk:        Low, balance is guaranteed, rate fluctuates slightly

Money Market:

  • 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

Stocks Market:

  • 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

Inflation:                    $10,185

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?

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17 Responses to Your Emergency Fund Strategy Could be a Waste of Money

  1. Right now I have a two types of bank account one is for savings account and one is for emergency fund. Honestly I’m a beginner about having an emergency fund and hopefully I will more savings for the future.
    Clarisse @ Make Money Your Way recently posted..Is blogging a MLM scam?My Profile

  2. The size of your emergency fund depend a lot on potential risks.
    For example, I know that I don’t have to care about medical emergency (what I need at hospital will end up in a 150€ co-pay), nor about unemployement (my unemployement coverage would be 60-70% of current salary). Nor about car accident (company car in leasing, if totaled I would get a new one)
    I have a life insurance for more extreme case.
    So in my “specific” case, 1000€ is more than enough, in case I need to replace a laptop/cellphone/washing machine.

    But imagine a family without social security at risks of expense in the thousands in case of hospital/ER visit. Or depending on a single income.

    Before calculating the return on the emergency fund, you need to decide for which emergency you are protecting yourself. Protecting from a job loss need much less liquidity than medical emergency.
    jp @cashsnail recently posted..Running update NovemberMy Profile

  3. I’m not sure the return on your money is really the focus of an Emergency Fund – it is for piece of mind. Yes, you might get an awesome amount in the stock market over a 30 year period, but what if when you need to access your money the market is down? You’d be taking a loss on that as well. I think liquidity is key when talking about an Emergency Fund (hence why I have a pretty heft one even though I’m in a good chunk of debt – it’s actually the topic of my post today).
    Alicia @ Financial Diffraction recently posted..Emergency Fund vs Debt Repayment.My Profile

  4. I think it’s important to note that there can be huge fees associated with taking money out of a whole/universal life insurance policy before a certain period of time has gone by. The hubs and I had a policy for a short period of time a few years ago (we have since cancelled it), but we would have had to keep putting in money for ten years before we would have been able to take anything out without penalty. Something very important to look into if you are considering this route- I’m sure that individual policies vary.
    Dee @ Color Me Frugal recently posted..Passive Income/Side Hustle Update: November 2013My Profile

  5. We keep most of our emergency fund in a Roth IRA. The principle can be withdrawn at any time without penalty, but by having it invested we’re able to earn more (and then earn on those earnings, of course!) We have $4000 in cash but I think we need to cut that down to $1000 – as you pointed out, most emergencies can be covered with that amount, so there’s no reason not to take advantage of putting your money in a place where it can grow!
    Kali @ CommonSenseMillennial recently posted..Achieving Goals: Power of Positive ThinkingMy Profile

  6. dojo says:

    My emergency fund is not for investing, is not even for earning me interest. It’s to get me out of any troubles, so that I don’t get into debt. So I don’t care if it’s in a bank, or in an envelope in my home. Everything above it is for investing or saving on various ways, but the ‘basic’ EF is there to get me out of trouble ;)
    dojo recently posted..Personal finance book: The Millionaire Next DoorMy Profile

  7. I absolutely agree with the line of investment that you are referring to.
    i personally think keeping money in banks is just a loss on investment opportunists.
    If one already have some insurance policies and with around 1000$ in saving account. One should invest money on bonds share market or any form of investment so that their money can grow.

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