by Elizabeth Aldrich | Nov. 29, 2018
What would you do if you found yourself in an emergency that requires you to come up with $1,000 in cash immediately?
From medical expenses to car problems, these kinds of minor emergencies are very common. Yet nearly two-thirds of Americans would struggle to scrounge up that $1,000 in the face of an emergency.
Not being able to come up with the money you need to cover unexpected expenses can lead to some pretty dire consequences. At best, you'll find yourself deeper in the hole financially because you'll end up with late payments or be forced to go into high-interest credit card debt, which can be very difficult to pay off. At worst, you won't be able to cover the emergency at all.
That's why having an emergency fund is so important. Saving a little money now can save you a lot of money in the long run.
That being said, no rule in personal finance is one-size-fits-all, and it might not be the best time to put away money into savings. Here are three situations in which you probably shouldn't start an emergency fund.
The cost of running into an emergency you can't cover financially is high, but the cost of not paying your bills is higher. If putting away money for a potential emergency would cause you to fall short on paying your bills, it's not the right time to start saving.
Consider that missing one payment could put a significant dent in your credit score and trigger late fees, putting you even deeper in the hole. If you continue to be unable to pay your bills and the late fees you've accumulated, you could get your services shut off, lose your rental home, or have your bills sent to collections. Having a bill sent to collections can really destroy your credit, and on top of that, they'll be able to garnish your wages, seize your personal property, and place a lien on your bank account. These consequences can take years to recover from financially.
It's still important that you build an emergency fund, but make sure all your bills are paid first. Consider looking for some side gigs or finding a way to generate extra income that you can put toward your savings.
If you're currently paying off high interest debt, such as credit card debt, that should be your priority. While you probably shouldn't drain your emergency savings account to pay off your debt, it's also not the best time to start one from scratch.
Emergencies have the potential to affect your finances, but interest rates are guaranteed to affect your finances. And if you're paying off debt at a 17% APR, you need to be putting every last penny of disposable income you make toward that debt if you want to avoid paying thousands in interest fees. Consider the table below that shows the amount of interest you'd end up paying on an $8,000 balance with a 17% APR given various monthly payments.
|Time to pay off balance||8.4 years||2.8 years||1 year|
|Total interest paid||$7,022||$2,119||$736|
Data source: Author's calculations.
As you can see, even increasing your payments from $150 per month to $300 per month saves you nearly $5,000 in interest and has you paying off your balance almost six years sooner. It's hard to argue the value of putting that extra $150 per month in an emergency savings fund instead, even if only for a year or two, when you see the effect that compounding interest has on your credit card debt.
If you're in a good place financially, have a high income, and plenty of liquid assets, you may prefer to invest that additional money rather than place it in a savings account. Savings rates, even with a high-yield savings account, will never net you big money. Even the best accounts only offer a 1.85% APY. The average rate is closer to 0.01%, which is lower than the rate of inflation.
On the other hand, a good investment account can easily get you 5% or more. So, you're losing out on that opportunity cost by not investing your savings.
Keep in mind that the function of an emergency fund is to protect you in case of emergencies, though, and not to provide you with high returns… or any returns at all. If you feel comfortable financially, you might want to put your emergency fund into a very low-risk portfolio that's easy to liquidate. A 401(k), for example, can't serve as an emergency fund because you can't readily access the money in it. Make sure that wherever you put your money, you can access it if you need to.
Whatever you decide to do, don't underestimate the importance of building an emergency fund. If you're not in a place to do so right now, focus on getting there as quickly as possible.
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