Financial emergencies come in big and small packages. On the extreme end of the spectrum, you might have lost a major source of income. Or, at the other end, your dog got injured and needs some pricey vet work. Either way, you're facing a financial situation that isn't accounted for in your budget.
That's the rationale behind having an emergency fund. You store up enough money to cover your household expenses for three to six months, and then you wait for something bad to happen. While that feels like a nice, conservative strategy, it may not always be the best financial move. Here are four reasons why.
1. You have high-interest debt
If you are rolling over balances on credit cards, saving money is going to cost you. Every $1 you save in an online savings account earns you about $0.02 per year in interest. But rollover that same $1 on a credit card and you'll pay $0.15 to $0.20 per year in interest. Said another way, if you have high-interest debt, saving money costs you 13% to 18% per year. Sadly, that means you really can't afford the luxury of saving money.
Instead, use all of your excess cash and earnings to pay down those credit card balances. You still face the risk of unbudgeted expenses, of course, but your top priority is getting out from under the debt.
2. You have a source of passive, stable income
If work is your only source of income, job loss can be catastrophic to your finances. In this scenario, an emergency fund acts as your safety net to cover those bills until you find a new job.
But what if you have another source of supplemental income? Say you have a side hustle, rental properties, or a portfolio of dividend stocks. If you're generating extra cash on the side, you already have a built-in financial cushion. The question is, how big is that cushion? Your need for an emergency fund depends on how well that secondary income covers your baseline household expenses.
Thinking through that scenario, you may decide that you can get by temporarily on your secondary income. That's awesome. That doesn't mean it's time to go shopping, though. You simply have more freedom to pursue other financial goals, like your retirement plan savings.
3. You have other sources of cash
You may have other sources of cash to get you by in a pinch. Perhaps you have a low-cost home equity line of credit, or access to a cheap loan from your 401(k). You might even have a brokerage account with equity assets that could be cashed out. These are all acceptable ways to cover your expenses in a true emergency -- as long as you are disciplined about paying back the funds fast.
4. You can put that money into higher-return investments
A conventional emergency fund sits in a cash savings account, which probably earns you about 1.5% interest annually. Keeping the money in cash gives you maximum flexibility to access the funds when you need them. The trade-off is in investment performance. A conservative investment portfolio might earn 4% or 5% annually, but then you are subject to short-term changes in value. If you lose your job the same week the stock market crashes, you might have to sell your assets at a loss just to free up the cash you need.
Still, you might decide to take that risk. Ask yourself what else you'd do with money that would otherwise go in an emergency fund. If you're paying down debt or increasing your passive income, that might work for you. If you want to buy a boat and host extravagant parties... not so much.
You can count on this: The future is unpredictable
What-if scenarios and spreadsheets are part of your financial-planning toolbox, for sure. But don't let your analysis lure you into forgetting this: The future is unpredictable. And emergency funds shine in unexpected circumstances, both big and small. Even if the math points you to a different answer, having an emergency fund always provides peace of mind. And that's pretty tough to quantify on a spreadsheet.