Do You Need an Emergency Fund?

We typically hear that everyone should have an emergency fund equal to three to six months (or more) worth of basic living expenses. But, do you really need such an emergency fund? I’m not sure you do.

Emergency funds give you something to fall back on if you become ill or disabled and can’t work, if you or your spouse lose your job, incur large medical bills, or have an unexpected large bill such as a major car or home repair.

Most households ignore this oft-heard emergency fund advice:

* 43% of households have less than $1,000 in liquid savings, according to SMR Research, a market research company.
* 28% live literally paycheck to paycheck, an ACNielsen poll found in August, with no savings whatsoever.
* Just three in 10 households have a cash hoard that would tide them over for a minimum of three months, according to Ohio University researchers.

I’m not convinced this is such a bad thing. Perhaps the whole idea that everyone needs a big pile of cash, and needs it right now, should be rethought.

What really counts is the resources you can command to help you withstand a crisis, even one that’s unexpectedly severe or long-lasting.

Consider what you have to give up in order to build your emergency fund. It makes no financial sense, for example, to have money sitting in a savings account earning 3% or 4% for years while you have credit card debt accumulating at double-digit rates.

And putting your retirement savings on hold while you save for emergencies could quite literally cost you a small fortune. Let’s assume you’re single, making $50,000 and that your company would match 50% of your 401(k) contributions, up to 6% of your salary. By not contributing 10% of your salary, you’re forever giving up $1,500 in free money (the match) plus paying an unnecessary $1,250 in extra income taxes each year (assuming you’re in the 25% federal bracket).

The biggest cost, though, is the future tax-deferred earnings you’ve forgone. Each year you don’t contribute, you’re costing yourself $65,000 in future retirement money (assuming your contributions, plus the match, grow at an 8% annual rate for 30 years).

Having a much smaller emergency fund, say one months worth of exepenses, can be perfectly legitimate, as long as you can quickly get your hands on enough money when you need it.

Having some cash can help you enormously in the first days or weeks of your crisis, but having access to credit can tide you over the rest of the way. For most families, the best borrowing for emergencies comes in two forms: credit cards and home equity lines of credit (HELOC). They are readily accessible and relatively inexpensive to have and to use.

Of course, you’ll want to be extremely judicious about how you use your credit. Credit can be an incredibly helpful tool, but like any tool, it can be misused. In a crisis, you’ll need to cut your expenses to the bone before you do anything else.

You also need to realize that this advice isn’t for everybody. If you’re a chronic overspender who can’t be trusted with credit, you’re better off going the all-cash route. But, if you consider yourself financially sophisticated, you may be able to find better ways to have your money work for you rather than having it disappear inch by inch as taxes and inflation take their toll.

Most people should at least think about the alternatives to tide them over as they consider building a traditional emergency fund. Either way, hopefully you’ll never have to use your emergency funds, but if you do, you’ll be much happier if you have a plan.