Everyone knows that having an emergency fund is a good idea. Personal finance gurus from Dave Ramsey to Suze Orman shout from the tree tops about the benefits of socking cash away for a rainy day.
Most of the time, the discussion about an emergency fund centers around two factors. Namely, that an emergency fund:
- Prevents you from resorting to credit cards to make ends meet
- Greatly reduces the possibility of being forced to tap your retirement accounts
I think all reasonable people can agree that these points are absolutely correct and I hope the message is resonating with the public.
However, I don’t think the emergency fund gets enough love. The advantages of having a stockpile of liquid cash on hand go far beyond avoiding debt or keeping your retirement accounts intact.
In fact, there are significant economic benefits that an emergency fund provides that I would argue are often missed. In addition, these benefits should be added to the otherwise pitiful interest rates on cash these days in order to derive the true “yield” you are earning from your savings.
Often, the additional savings you might derive from these ancillary benefits could amount to more than your bank pays you in interest every year!
With that in mind, let’s take a look at four less obvious benefits of the unloved emergency fund:
1. An emergency fund increases your ability to take risk with your investments
Let’s assume for a second that you have $0 in savings outside of your retirement accounts. If you lost your job at the same time the market was in steep decline, you’d probably find yourself in a pretty difficult position.
Your day-to-day life would be greatly affected and you’d likely be forced to take withdrawals from your retirement accounts (thereby locking in losses and probably incurring taxes and penalties as well).
On the other hand, let’s say you have a solid emergency fund in place. This time your emergency fund steps in to provide for your living expenses until you find a new job and your retirement accounts remain untouched. Effectively, you’ve insulated your daily life from the volatility of the market.
In the first scenario, it would probably be foolish to invest 100% of your account in stocks since you might actually need the money well before retirement. However, assuming you had a long enough time horizon and could emotionally tolerate the ups and downs, it’s feasible that in the second scenario you could own an all equity portfolio.
Long story short, the protection that an emergency fund offers means that you might be able to increase your allocation to stocks in your retirement accounts *and thereby increase your long-term expected returns).
2. An emergency fund allows you to increase your insurance deductibles
I spend quite a bit of time reviewing the auto, homeowners, and renters insurance policies of my clients. My goal in doing so is to help them better understand their policies, make recommendations to provide greater protection, and to identify any gaps that may have been overlooked.
I’m also focused on strategies to help them save money on their premiums. One way to do this is by raising the deductibles on their policies.
Assuming the client has built up an emergency fund of at least six months of living expenses, they are in a great position to increase their deductibles, which can save them hundreds of dollars or more every year.
Often, we can then take this savings and apply it towards improving their coverage. For example, raising the deductible on an auto policy often generates enough savings to purchase umbrella coverage.
No matter how you slice it, an emergency fund gives you a lot of options when it comes to your property and casualty coverage.
3. An emergency fund gives you the flexibility to pursue new opportunities
If you’re like most people, you’ll probably experience a handful of instances during your lifetime that have the ability to completely change your trajectory.
It could be a new job half way across the country. It might be an opportunity to take time away from work to travel or to volunteer for a cause you really believe in. Maybe a friend approaches you about starting a company.
Whatever it is, it could be life changing in a very positive way. However, a lot of these opportunities require you to give up a steady paycheck for awhile.
With a solid emergency fund in place, you can consider the opportunity without worrying nearly as much about managing through the day-to-day.
Without one, you’re left wondering whether it’s worth it to raid your retirement account or take on a bunch of debt in order to pursue the opportunity.
4. An emergency fund might allow you to switch from a traditional health plan to a high-deductible plan
Lately, almost everyone has felt the effects of rising healthcare costs. It hasn’t been uncommon for insurance premiums to jump by 10%, 20%, or even 30% from one year to the next.
Likewise, employers are shifting more of the burden to employees by raising the amount you need to contribute towards your plan.
One option to help stem the impact of higher premiums is by choosing a high-deductible health plan (HDHP).
Keep in mind that every situation is different, but often the lower premiums combined with an employer’s contribution to a health savings account (HSA) can make an HDHP a big win.
That said, until you build up a sizable HSA balance (which in reality is a form of an emergency fund in and of itself), an HDHP probably isn’t a good idea unless you have cash available to pay for deductibles and co-insurance.
If you have your emergency fund built up, you could easily cover the larger out-of-pocket costs of an HDHP. This could mean thousands in savings on your premiums every year.
The persistently low interest rate environment has caused many investors to second guess the wisdom of keeping a large emergency fund on hand.
However, if you fully leverage the power of your stockpile of cash, the ancillary benefits can outweigh the interest you might earn even if rates were much higher.
And just remember that even if you take your emergency fund for granted and don’t give it the love it deserves, it will always be there when you need it!