An “emergency fund” is an age old standard part of organizing personal finances. The reasoning is that having a set amount of cash at all times allows you to handle emergency expenses without going so far into debt that you can’t get out.
There is wisdom in that advice. It would certainly put a hamper on your early retirement timeline if you had to spend all your money paying off high interest debt.
But – I purposely didn’t title this “FI Fundamental #3: Have an Emergency Fund.”
The reason for this is that cash earns very low interest. It’s so low, in fact, that when you consider inflation, you actually lose money when it sits in a savings account (even one of those “high interest” accounts earning 1.05%).
And, since you already have a high savings rate due to your low spending, you can cover most unexpected expenses on your own.
The typical advice
There are many places you can go on the Internet that discuss personal finance, and I’ll bet over 80% of them say to have “three to six months’ worth of spending” in cash.
It is probably the best option for the general population, especially those just starting to organize finances, or those particularly risk averse. (It’s better safe than sorry…)
The problem is that the emergency fund is then limited to living its days in some pretty boring, low risk, low return, cash accounts: savings accounts, CD’s, I-bonds, etc. As aspiring early retirees, we want our money to grow as fast as reasonably possible.
I consider the pursuit of financial independence to be “advanced” personal finance, so if you’re a fellow FI’er (I assume you are…why else would you be here?), you probably won’t want to settle for a measly 1% return when you know that you can expect around 7% invested in stocks.
Enter the darling of economics, opportunity cost. According to our friends at the New Oxford American Dictionary, opportunity cost is:
“the loss of potential gain from other alternatives when one alternative is chosen.”
In other words, it’s the difference between the value of your money if it were invested versus if it were sitting in a savings account.
For example, Bob spends $20,000 per year. If Bob follows the typical advice, he has $10,000 in a savings account that stays there earning 1.05% indefinitely. But, what if he invested that money in the stock market instead, earning 7%?
As we can see, the opportunity cost after 10 years of Bob’s money sitting in a bank account rather than invested is $8,570! He could have 77% more money if that had been invested. And that doesn’t even consider inflation. C’mon, Bob.
However, everyone will probably encounter some sort of unexpected expense, and you don’t want to have to sell stocks in order to pay for it. So what should you do instead?
Given our high savings rate, we would be able to fund most “emergencies,” like a car repair, almost immediately. But, it is still worth considering what would happen in the very unlikely situation that we both lose our jobs at the same time and therefore have to live without any source of income for six months.
Our monthly spending target is $3,000 per month. If we were to follow the conventional advice and keep an emergency fund with six months’ worth of spending, we would have $18,000 sitting around doing nothing (most of the time). Let’s review why we wouldn’t want to do this:
- There’s a significant opportunity cost for that cash
- The probability of both of us losing our jobs within the same six month period is very low
- Even if we did lose both our jobs, we would (probably) receive severance compensation
- We would cut back our spending to cover only the “necessities”
In reality, if something did go wrong, we could cut back on our spending to less than $2,000 per month, but to stay conservative, I prefer to estimate around $2,500 per month.
But, even at $2,500 per month, that’s $15,000 sitting in a bank account that we would rather be putting to use. So, given the extreme unlikelihood of us both losing our jobs at the same time, we are comfortable using debt.
Currently, we do not own any valuable property like a house that we can borrow against (such as a HELOC, like the folks at Early Retirement Now). Our only easily accessible line of credit is…a credit card (gasp!). Here’s the process:
- Our only monthly spending obligations would be the expenditures that can only be made in cash (rent) and the minimum payment on the credit card (3% of the balance or $25, whichever is greater).
- Everything else would go on the credit card, and we would only pay the minimum.
- We should be able to reestablish income after six months and then immediately pay off the balance.
This strategy allows us to minimize the amount of cash we have on hand and invest as much as possible. Here’s the calculation for how much cash we would need, assuming 14.99% APR:
The column in the far right is the amount of money we would need to have in cash each month. After six months, this totals to about $8,200.
If we assume that we would use this strategy once over the next 10 years (again, this would be highly unlikely), we would incur a cost of $450 in interest. But, it would allow us to keep only about $8,000 in cash, instead of $18,000 like the typical advice. This allows us to invest the difference ($10,000). Using a conservative growth of 5%, that $10,000 that we invest will grow to over $16,200 in 10 years, a gain of $6,200.
So, the opportunity cost of keeping that money in a cash account and not using our credit cards is $5,750 ($6,200 – $450). In other words, we would come out ahead by at least $5,750, even if we had a six month period in which we only made the minimum payment on our credit card.
We actually keep $3,000 in checking (for monthly expenses) and about $2,000 in savings, so in reality, our “emergency fund” is even smaller. The rest of our wealth is invested or set aside for upcoming expenses, like our planned trip to Ireland in 2018. If we really had to, we could divest some of our stock holdings to support long periods of lost income.
I am by no means condoning the habit of carrying a balance on credit cards.
We simply believe the possibility of getting into this situation is extremely low, so the risk of paying the high interest on the credit card is justifiable given the higher return of investing the excess cash we would keep if we followed the typical advice.
VERY important caveat
If I haven’t already said it enough, the use of high interest debt (like a credit card) should only be used in extreme situations, and you should have a well thought out plan to pay off that debt.
This is “advanced personal finance,” so for business-as-usual-fully-employed situations you should only use credit cards for the cash back benefits and pay off the balance every month.
If you currently carry a balance on any credit card, I do not recommend that you rely on credit cards in lieu of an emergency fund. Instead, you should focus your money on paying off the credit card debt.