Emergency Funds are a crucial part of your financial health, protecting you from unexpected expenses that can have a serious impact on your finances. But emergency funds can represent a significant amount of money that is sitting idle, typically 3-6 months worth of expenses. So, this begs the questions, is it okay to invest your emergency fund?
Emergency Funds should not be invested. Emergency funds exist as a reserve to cover any unexpected expenses, and they need to be liquid and safe. Investing your emergency fund may result in having less money than you expect, or that the money is illiquid and can’t be accessed when you need it.
Emergency funds are better suited for a high-interest savings account, where it is safe and the money is easily accessible. Read on to find out more.
Why You Shouldn’t Invest Your Emergency Fund
The characteristics of a good emergency fund is liquidity and safety.
Liquidity is the ability to convert your value to cash and make use of it. Safety is the confidence that your money will be there when you need it, in the amount that you expect it.
By investing your emergency fund, you are potentially taking risks with the money, and may reduce liquidity. Instead, it should be held in cash, ideally in a high-interest savings account
The Purpose of an Emergency Fund is to Protect You, Not to Grow Your Money
The point of an emergency fund is to provide you with money to cover expenses that you can’t budget for.
This may be an unexpected car or home repair, emergency medical expenses, or covering lost income due to a job loss. By having an emergency fund in place, you can quickly cover these expenses without taking more damaging action (see more below).
Emergency funds can be thought of as an insurance policy. Insurance policies aren’t in place to make you money, but rather to prevent you from losing it in the case of an accident.
Once you save up your emergency fund, there’s no continued payment, but you do have opportunity costs. Compared to investing in the stock market, even if it’s in a high-interest savings account, emergency funds will provide less return. In fact, your money may lose value with inflation.
But the point of an emergency fund is not to get a return.
The lost return on the money held in an emergency fund will be marginal compared to the money you’d lose having to take on expensive debt.
It may not feel good to have the money sitting idle, but you’ll be thankful you have it when an emergency hits. And if you are still uncomfortable with it, you can explore Alternatives to an Emergency Fund, but emergency funds are still the best choice.
Investing Your Emergency Fund Could Put the Money at Risk
Investing inherently comes with risk.
By investing your money in the stock market or elsewhere, you are taking a chance that value could be lost. And losing money you’ve set aside for an emergency is not a good idea.
Let’s imagine you have your emergency fund invested in the stock market in the lead-up to the great recession (2008-2009). At it’s worst, the S&P was down >50%. And the great recession resulted in an average of 700,000 Americans losing their job each month.
Imagine you were one of the unlucky people who lost their job, only to find the money you’d set aside to protect yourself in this circumstance had been cut in half. Unfortunately, the times you need the money often coincide with when markets would be down.
Investing Your Emergency Fund Could Mean You Can’t Access the Money When You Need It Most
The best emergency fund is liquid, meaning you can easily access your money when disaster strikes.
If you’re invested in stocks, you may be able to quickly sell to get cash, but other types of investments may not be as liquid. Imagine you had money in collectibles, and quickly needed cash. It may take some time to find a buyer, and even then, you may be selling at lower value since you need the money fast.
You’re best to hold your emergency fund in cash.
The Bottom Line
The bottom line is emergency funds should not be invested. Investing your emergency fund can mean it loses value when you need it most, or that it’s inaccessible in case of emergency. Emergency funds are best held in cash in a high-interest savings account.
What Happens if You Don’t Have Enough in Your Emergency Fund?
If you don’t have enough money in your emergency fund, you may have to take more damaging action to deal with an emergency expense. This could be taking on (potentially expensive) debt, borrowing from friends or family, or a fire sale of an asset.
If you don’t have an emergency fund in place, you may need to borrow money to cover unexpected expenses. Often, this takes the form of credit card debt, which as of this writing, had an average of 27% interest in the US. This interest can quickly compound, and take years and years to pay-off. This can damage your credit score, financial health, and overall quality of living for years to come. Even if you have access to lower-interest debt, you’re better to have an emergency fund in place to prevent this.
Another option in the absence of an emergency fund is borrowing from family or friends. However, this can be incredibly damaging to the relationship, and to the financial health of one or both parties. In fact, according to a 2019 survey, more than a third of people (35%) who have lent money to friends or family have lost money, damaged their credit, or harmed the relationship. This is a situation you should avoid wherever possible.
Lastly, not having enough in your emergency fund may force you to quickly sell an asset. This is typically done at a reduced price relative the actual value. For example, if you’re short on money you may sell a piece of jewelry that has been in your family for generations. On top of losing the family heirloom, since the sale was rushed, it was likely sold at less that it was worth.
All in all, you’re best to make sure you have a well-stocked emergency fund, with 3-6 months of living expenses.
What Happens If You Have Too Much in Your Emergency Fund?
In general, having too much in your emergency fund will result in opportunity costs.
This means that by holding that money in cash, you’re missing out on the opportunity to grow it through investing. Now as mentioned above, your emergency fund is not meant to grow your money. But by having too large of an emergency fund, you’re sacrificing growth unnecessarily.
But how much is too much? The typical recommendation is to hold 3-6 months of living expenses in your emergency fund. Now the dollar amount will depend on your monthly expenses, your risk factors, and your aversion to risk. If you want to find out how to assess how much you need, read more here.
Ultimately, so long as you have assessed your risk factors, and decided on an amount that’s appropriate for your life, anything more can be invested.
What Shouldn’t You Spend Your Emergency Funds On?
Emergency funds should only be spent on emergencies. An emergency is any expense that is unexpected, and out of the ordinary (like a sudden car or home repair). Emergency funds should not be spent to fund your lifestyle.
An emergency expense should be an expense that you could not predict or could not predict the timing of. An example is a car repair. When I brought my car in for a routine inspection, I was hit with $2,500 in brake work. Even if I knew my car needed work, I couldn’t have known when the expense would come. In this circumstance I was happy to have my emergency fund.
Emergency funds should not be used on non-necessities. This could be things like vacations, gifts, a new car you don’t need, etc. Using your emergency fund for these things mean the money won’t be there if a real emergency expense comes.
Emergency funds also should not be used to fund your lifestyle. If you find at the end of the month you need to dip into your emergency fund to pay off your credit card, despite no major expenses occurring, that’s likely a sign you’re outspending your income. This should be a wake-up call to re-examine your budget.
Ultimately, by spending your emergency fund on a non-emergency, you’re only hurting yourself.
How Aggressively Should You Save For Your Emergency Fund?
In general, you should be saving at least 20% of your take-home paycheck. In the absence of debt, you should be allocating this money to your emergency fund. And if possible, you should be allocating even more until you’ve built up 3-6 months of expenses.
Using the 50/30/20 budget method, you should be allocating 50% of your monthly income to needs, 30% to wants, and 20% to savings. While you’re building up an emergency fund, that 20% should be going entirely to your emergency fund. Assuming your expenses are 50% of your income, each month of emergency fund should take about 2.5 months (50% divided by 20%). So, if you’re saving 3 months worth of expenses, it’ll take 7.5 months, and 6 months of expenses will take 15 months.
Now in the short term, while you’re building your emergency fund, it likely makes sense to sacrifice your lifestyle. This does not mean never doing anything fun, but it does mean being thoughtful about looking for places where you can save money. It also means avoiding big expenses like vacations or other large purchases until you’ve build the foundation of your financial health.
If you can either reduce your expenses, or increase your saving, your time to save an emergency fund can get cut down dramatically. Let’s imagine that you’re able to save 30% and spend 20% on wants. The remaining 50% is your living expenses, but because you’re able to save more, each month of emergency fund only takes you 1.66 months (50% divided by 30%) instead of 2.5. This means that 3 months of expenses will take 5 months to save for, and 6 months of expenses will take 10 months.
Ultimately, you can play with these numbers to see how various spending/saving scenarios result in a timeline for building an emergency fund.
Is it Better to Pay Off Debt or Save for Emergency Fund?
Whether to prioritize debt or emergency funds depends on the type of debt. You should always pay the minimum payment on your debt, but additional funds will depend on if it’s good debt or bad debt. Good debt can be serviced alongside funding your emergency funds. Bad debt however should be paid off before building an emergency fund.
There are differing opinions on debt, but some types of debt are certainly better than others.
Bad debt (e.g. credit card debt) is typically high interest (20%+) and is the type of situation an emergency fund helps you avoid. But if you’re already in this situation, you’re best to deal with it first before building an emergency fund.
Good debt (e.g. mortgage) is typically low interest (<7%) and has a long amortization period. If you’re carrying this type of debt, you’re often better off continuing with your payment schedule, and building your emergency fund with any additional money.
Read more on this topic here: Emergency Fund Vs. Debt Repayment: Which is Better For Wealth?
What Are Some Common Emergency Fund Mistakes?
There are plenty of mistakes that can be made with emergency funds. Examples include having too much or too little, holding it in the wrong account type, and more.
Read more on emergency fund mistakes here: 10 Common Emergency Fund Mistakes to Avoid
All in all, investing your emergency fund is not a good idea (see a regretful individual here). You’re much better off to hold it in a high-interest savings account, and invest other funds you have.