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?

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.

  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.

    • I agree with your analysis, JP and is really one of the points I was trying to make. The vast majority of life’s emergencies don’t require more than $1000, so the rest of your funds can be put into something less liquid, and thus allow for options that give a higher rate of return.

  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).

    • ugh, and obviously I meant “peace of mind”, and heft=hefty. Too early in the morning here in North America to write coherently, apparently.

      • Agree Alicia…I wouldn’t put my efund funds into the stock market either as it’s too high risk with respect to the piece of mind of being able to handle emergencies while the market is up or down. That being said, I think there are smarter things that can be done with the emergency fund money than sticking it a savings account that doesn’t keep up with inflation. Thanks for stopping by, and for the exchange of ideas!

  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.

    • Great point, Dee…it is very important to become familiar with the terms and conditions of your options before sinking your money into it. My whole life insurance policy actually does not charge any penalties for taking cash value out – but I don’t doubt that other policies would. Thanks for stopping by!

  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!

  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 😉

    • I don’t disagree with the basic need and concept for the emergency fund – but I think there are ways that we can be smarter with those funds to have it available for an emergency….AND make it grow at least a little bit. 🙂

  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.

    • I’m glad to hear people agreeing with me, Ronald…of course we also have to keep in mind risk. If it’s an emergency fund we want it to grow, but we also want it as secure as possible.

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