Emergency funds are a controversial topic that have always irked the writers here at DQYDJ.
Okay: overall, we think they are a decent idea... but the singular focus on obtaining one despite the (usually ignored) costs is the incorrect focus for most financial prioritization decisions. In this series, I will lay out three reasons why emergency funds should not be your number one personal financial goal... I look at them more as a luxury good; something to have when your basics are in order. And, when you do decide to establish one, there are methods (such as the HSA-method laid out by my colleague PK) that can improve the tax benefits of having an EF.
Too often, EFs are prescribed as the be-all and end-all of financial goals and I will show you why this shouldn't be the case.
Get cash-flow positive!
The first step towards financial freedom is achieving a positive cash flow. All the following arguments are null and void if you are bleeding money every month. The solution to this is outside of the scope of an emergency fund... it can only be fixed by either increasing your income (side projects, second job, new job, promotions, etc.) or lowering your expenses (cutting cable, lowering discretionary spending and removing debt). Here's a good primer - our one article complete Personal Finance overview.
With a positive cash flow, you are able to handle small shocks to your income. Your tire deflates? Well, that $100 replacement can come out of the monthly cash flow. (This is not an emergency.) Many, many situations where an "emergency" comes up, it is simply wear and tear and standard maintenance. One obvious one: if you have a house, expect to pay 1%-2% in maintenance fees every year. When your refrigerator dies, you should not be scrambling to pay out of your "emergency fund".
In short, my contentions with emergency funds as a prescription for everything are the options for better uses of the now-locked-up cash: either cheap debt or investing. If you are cutting your 401k investment below your employer match, you are wasting money. If you are not maxing out your Roth IRA annually, you are wasting tax benefits and potential stock market gains. If you have credit card or other semi-high interest debt, you are wasting money by not paying it down and saving on interest. Not to mention: your EF consistently loses its value to inflation.
Are you cash flow positive? Good. Now we can talk about why Emergency Funds are a luxury good.
Credit Limits and their Usefulness vis a vis Emergency Funds
I have $35,000 in total credit limits on my credit cards and I currently carry $0 in balances.
This is one of the many advantages of using credit wisely: I am able to reap the rewards of my cards (Capital One Quiksilver, Chase Freedom and Amex Blue Preferred) and not pay any interest. In case of unexpected expenses, I can handle minor month-to-month shocks using my credit card.
The idea of an emergency fund is that these events should be rare. Rare as in once every two years rare. If you are constantly dipping into your emergency funds every few months, these are not true emergencies and should be accounted for in your monthly budget. The price of having an emergency that my cash-flow can't handle? Well, I might need to carry a little balance for one month. This is worth the risk of ensuring that my other financial goals are being met first and foremost. Do the math.
Get out of high-interest debt first. I cannot stress this enough. If you are carrying credit card debt, you are already in an emergency and you should pay this down first. Your cash will then "earn" the APR on the credit card and if you need the credit limit later on you can simply add it back on. There is no instance where I can imagine carrying the debt and keeping the cash. I have seen the advice of gaining an EF before paying down CC debt too many times to overlook this point.
What about a job loss? I will cover larger emergencies in my next two articles and share why most "emergencies" are not true emergencies in the sense of the word. I will also share better methods of storing your money than in cash.