FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 4.1: Your Emergency Fund
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
Let me reiterate an important fact: Credit cards are evil. You should have a couple, but you should never use them unless you have the cash to pay them off completely at the end of the month. Most of us live paycheck to paycheck, and we have (usually accidentally) budgeted such that after we’ve paid the bills and bought some groceries, there is not much left. When something out of the ordinary happens, we are forced to use revolving credit accounts (that’s what finance folks call super-high-interest-rate accounts that you can make monthly payments on and never get paid off) to take care of the problem. The washing machine died! No problem; go to Home Depot and put it on the card. The transmission died in my car! No problem, get a new one put in and put it on a card.
The problem is that with the interest rates credit cards charge, you’ll take 10 years to pay off a $1000 washing machine and have paid $30,000 for it. A couple of emergencies later, and you don’t have enough money to pay the bills. Something has to go, and you don’t pay the credit cards (because you correctly determine that running water and electric lights trump Visa as a priority). Your credit score tanks, your car insurance goes up, you can’t rent a house, and the bank will not give you a loan for a car or a home. Your dream job comes open, but they can’t hire you because of your credit problems.
If credit cards are so evil and are to be avoided at all costs, what is a person to do when the unexpected happens? Start an emergency fund! This is a bank account where you stash away money for when bona fide emergencies arise. Most financial planners will tell you that such a fund should contain a certain number of months take-home pay. For a young person just starting a career, I suggest setting a dollar amount goal of around $5000. That is enough to pay for most major appliances, most car repairs, and put a down payment on a car if you absolutely must do so quickly. It should also pay a couple of month’s bills if you find yourself between jobs. The more responsibility you take on (children, mortgages, spouses, etc.) the more you will need to start thinking in terms of salary replacement.
For the sake of argument, let’s say you have $1000 in your bank savings account. Let’s further assume that your money is earning 1.00% Interest. As crazy as it may see, that is a good rate for a savings account in the 2017 market. Interest rates for savings accounts are at rock bottom. We’ll use this meager return as an example of why the Magic of Compounding Interest is both impressive and desirable.
In a simple world where math is infrequent and universally disdained, you would simply let your money sit in the savings account, and, at the end of the year, the bank would deposit $10 interest into your account. In that simple case, you would then have $1,010 in your savings account. In that scenario, your gains are due to simple interest, which the bank only pays on the principal (your original $1000). The mathematical complexity arises when we consider that banks usually don’t work like that. More often than not, you make money on your principal as well as on the interest that you have already earned. That is what Jim Cramer would call a “high-quality problem!”
When banks pay interest on the principal plus the interest already earned, we call it compounding. When choosing an account, it is important to know how often the bank compounds the interest. As a general rule, the more frequently the bank compounds your interest, the faster your money will grow. Some banks compound daily, while others do so monthly or quarterly. Obviously, I’d prefer my money to make me money every day and not just once per month or once per quarter. Note that this works against you when you hold credit card debt; most credit card companies compound what you owe them daily. In the case of daily compounding, your money will earn 1/365th of the 1% annual rate each day you leave it alone and let it grown. This quirky calendar may sound like a small detail, but over a ten year period, daily compounding can add about 10% more profit than you would earn with simple interest.
Savings Accounts are Terrible Investments
At the end of 10 years, then, your $1,000 investment would grow to an immense value of $1,105.17 with compound interest. Even with the miracle of compounding interest, that is still depressing. There are two lessons here. The first may not be so obvious: Compounding interest is amazing, and you want every dime you can get invested so it can contribute to the compounding process that will make you wealthy. The second lesson is that 1% is a terrible rate of return, and you will never grow rich tucking your money away in a bank savings account.
In reality, the only reason to use a savings account is the psychological barrier it places between you and your money. Most people have trouble letting cash sit in a checking account without dipping into it. You absolutely must have an emergency fund that you will not touch except in a bona fide emergency, and most of us have the discipline not to rob our emergency fund if it is walled off from our ATM card by a savings account. Why do we not invest it in equities so it can compound? The reason is what money managers call liquidity. You need your emergency fund hidden away psychologically so that you do not raid it, but you need to be able to access the cash quickly when an emergency arises. If your money is in your investment account, the market may be down, or it may take several days to transfer the money into your savings account.
The key to an emergency fund is to be very disciplined about defining an emergency. If you could have foreseen something coming, then it is not an emergency. It is just an expense. Expenses should be part of your budget, not taken out of your emergency fund. Let’s say you have an old vehicle that runs okay but has seen better days. It has 197,000 miles on it and smokes a little when you first crank it. That situation says you need to budget a separate pool of money; call it your “car fund.” You see that it’s coming, and it’s foolish to not be ready for it.
The person with discipline and wisdom will save enough to pay cash for the car upgrade (notice I didn’t say “new.” New cars are always a colossal waste of money) and avoid bank interest entirely. If you can’t do that, then you need a sizable down payment. Lenders love folks with great credit scores and give them the best rates. They also love folks with big down payments. If you have awesome credit and a big down payment, you’ll get the best rate possible. However your circumstances move you to act, you should never touch your emergency account for a foreseeable event such as a new car.