Why Emergency Funds Can Provide The Best Return On Investment

Many recent articles and surveys have illustrated how many American are basically living paycheck-to-paycheck, with no significant savings cushion:

Along the same lines, a reader introduced me to an interactive poverty “game” called Spent, in which you try to make it through one month as an unemployed worker looking for a job and housing with their last $1,000. Try it out, and you’ll have to make some touch choices.

In just one month, I managed to get sick, need dental work, receive an undeserved traffic ticket, my best friend gets married and I can’t go, my mom needs money for medicine, my landlord raises the rent illegally, and my child refuses to eat the government-subsidized lunch. Seems a bit unlikely, yes. But a combination of a streak of bad luck and lack of support is exactly how you might end up in such a scenario.

In addition to the societal issues this brings up, from an individual point-of-view, I found that this simulator shows how living close to the edge is often significantly more expensive than someone with a cash cushion. Being poor can cost more than being rich. Consider the following:

  • If you don’t have enough money for a security deposit, you’ll have a hard time renting an affordable apartment. Many renters are thus forced into long-term motels that actually charge more on a monthly basis.
  • If you can’t afford a car repair, you can’t make it to work and face the prospect of losing your job.
  • If you don’t pay for preventative medicine, you can end up needing more expensive treatment later.
  • If you have a low balance on your bank account and overdraft by just $10, you’ll get hit with a $35 overdraft charge.
  • If you just don’t pay the bill, you’ll get a late fee charge.
  • If you don’t pay the bill for consecutive months, you’ll get your gas/electricity service shut off and be subject to an additional $250 deposit to get it back on.
  • If you charge any of this on a credit card and don’t pay off the balance each month, you’ll owe 15-25% interest. That’s if you have the credit history to get a credit card. If you go with a payday loan instead, you’ll owe more than 100% annualized interest.

For this reason, one of the first financial steps a person should take is to save up a cash cushion. That emergency fund can easily save you more money than a 20% increase in the stock market. I would tell my own child to forget saving for retirement until you have a least a couple months of expenses saved up. Luxuries like smartphones, alcohol, cable TV, and dining out should be off-limits until then as well.

One should expect “unexpected” expenses. Even though I have a relatively high income, I place great value on my emergency fund.

Comments

  1. Interesting. It was a good exercise.

    The first attempt I ran out of money in 5 days. 2nd time I made it through the whole month.

  2. I don’t agree with a lot of his investment advice but I’m thankful that 12 years ago I discovered Dave Ramsey and he pounded on the idea of the “Emergency Fund”. We’ve never had less than $1,000 in a cash emergency fund and have built up 6 months of expenses over the years. You hit the nail on the head about luxuries coming after an Emergency Fund. It really comes down to budgeting. If you budget and take a hard look at what’s necessary and what’s discretionary you can find $1,000 in a short time with almost any income.

  3. josefismael says:

    Made it through the month with $605 to spare, well on my way to rebuilding a respectable emergency fund. Hopefully this McKinney group is spending some of the money I donated towards education and awareness for those in need. Teach a man to fish and all that…..

    Also – $30 for laundry? Am I getting everything dry cleaned or something?

  4. josefismael, the $30 for laundry may be the total cost for a month or something. $7.50 a week is not unreasonble at a laundrymat. Its fairly common for it to cost $1.5 per use of the washer or dryer so $3 per to wash & dry. Or they might be using some average number on what average households spend derived from 2.9 people per house or something like that. Some of their numbers seem like nationwide average type figures.

  5. Coin laundry in an apartment building — it’s far more expensive than it probably should be. $2.75 to wash and dry every load — what I pay now — adds up really fast. I had bought my family a washer/dryer since that’s just what you do in a house; I hadn’t considered that they would pay for themselves in only two or three years. Now that I’m alone in an apartment, I have a new $20ish monthly utility expense to which I hadn’t initially given much thought. And of course it’s much higher for families.

    It is immensely frustrating that many folks simply cannot or will not budget. It’s really not hard, and it’s quite stark how much more more money you’ll have if you do.

    One item missing from the list above: those insidious Payday Loan/Advance shops. For a “small fee”, they’ll give you an advance on your paycheck. If you run the numbers on the amounts and the time interval involved, it’s the equivalent maintaining a balance on a 35+% interest credit card.

  6. Amen.

    This is a REALLY good post.

    I have personally always had a decent cash savings cushion. When people tell me that it’s “stupid” to have so much in cash, I have never agreed. Life experience tells me otherwise. Basically, always having had a decent cash savings, you couldn’t sway me to give that up. & I do not identify with the financial struggles of most my cashless peers, no. (Plus, since I am not dealing with all those little minor pitfalls, I have more to put away for retirement, college, to stay out of debt, etc.). Anyway, you put into words what has been hard for me to get across to others.

  7. Sarah in Iowa says:

    Josef Ismael, $605? wow. I made it with $223, but as it reminds me, rent is due tomorrow :P

    I tried to do mostly what I would do in real life, so I guess it’s good I made it through the first time. Oh yeah, except I did drive away after I hit a parked car. BUT I had paid for car insurance, so the options weren’t really valid. I could pay $550 to fix the other vehicle, but if I were at fault I wouldn’t have to do as the insurance would cover the other vehicle. The only other option was to drive away, which I would never do in real life. :)

  8. For a paltry sum like $1,000, who doesn’t have a credit card that would cover that?

    Most people also get paid twice a month. If they can’t figure out how to pay off a small ‘emergency’ on a credit card in 4 pay periods… Then an emergency fund is the least of their worries.

    FUD such as these articles do more harm to financial literacy than even the ‘WE BUY GOLD’ advertisements everywhere.

  9. @Anonymous – So, your assumptions for everyone are:

    1) $1,000 is “paltry”, as opposed to perhaps a big chunk of their take-home income.

    2) Along the same lines, $1,000 can be paid off in 4 pay periods, meaning they have $250 to spare each pay period above their other expenses like taxes and health insurance.

    3) They have a job for the next two months.

    4) They have a credit card with $1,000 of available credit. 30% of people have no credit card.

    5) The expenses incurred accept credit cards as a form of payment.

    If all these things are true, then your proposal is for everyone to just put things on credit card and pay it off over two months, as opposed to having a cash cushion where future cashflow is not depended upon. This is “financial literacy”?

  10. Interesting game, although there are errors with it.

    $100 for nice shoes? Cmon. I am running a marathon and I went to the store to get fitted for special shoes and even those cost less than $100. A parent on the edge of poverty who even considers spending money on designer clothing is always going to be a failure and will deplete any emergency fund fast.

    Those facebook posts? Cmon. There are more subtle ways to deal with needing help.

    Also many districts have electronic pin entering for lunches so others don’t know if it’s free. Mine certainly does.

    In the case of the game, an emergency fund was not the problem. The negative cash flow was the problem… the emergency fund would have only bought some time. Basic solutions like getting a roommate would have gone a long way.

    The real take home lesson for me is what can we do as a country to help.
    1. Free basic health care
    2. Better public transportation system. We currently give subsidies to roads/solo drivers.
    3. Better sex. ed. based on research, not religion. No reason so many poor single people need to have children. Abstinence only education is a miserable failure.
    4. Support unions. Workers deserve a living wage. Inexplicitably much of the counry is anti-union today… I think we are brainwashed.

  11. I really believe in the emergency fund. While $1,000 is a great start you should really shoot for 3-6 months of living expenses. We have a 3 month emergency fund and it has saved up so many times with unexpected expenses.

    As far as the comment from David, I am glad that he would like all of these things in place. My question would be how do you pay for it? Oh, let me guess more taxes on the wealth right?

  12. Good post. As a frugler, Candidate for CFP and Realtor, first thing I ask before I help people on financial planning is to whether they have emergency fund, I call it as life saver fund. I myself have different buckets/savings account in ING for each and put them every month and follow pay yourself strategy. Thats the way to go and save for every unexpected moment.

    It was really nice game to go through the psychological aspect of life without money. I was able to make it through the month in first attempt and had balance of $65 at end.

  13. @ Sarah in Iowa: Regarding the $550 cost in the scenario for hitting a parked car and having insurance, it really depends on your insurance. In this scenario, it cost something like $100 per month for the car insurance. In many metros, insurance which included liability coverage at that cost would still require a deductible.

    And that is the short term cost. I recently had a parking lot incident – my fault – that was $600 in damage to the other car. I have a low deductible on collision. I called my agent, who informed me that quite likely it would cost me more in increased (and ongoing) premiums over the next *several* years than the $600 out-of-pocket today.

  14. Great post. I found myself thinking of that game all day… Yes, it’s a bit unrealistic if you take it at face value, but think about this; if you are out of work, it’s probably not going to be for a month — not in this economy. This is a condensed simulation. Taken in that context, it’s realistic, and a sobering lesson.

    P.S. Nice zinger in your comment… Anonymous’s post cracks me up.

  15. There are lots of details to niggle. I tried to live close to my job so I wouldn’t need a car, but the game told me I needed one anyway and charged me more money on top of my higher rent. Boo. But this is not the point of the game.

    Instead, focus on the fact that you need a safety net. If you don’t have the government or your parents or (fill in the blank) to act as one, then you’d better start making one for yourself.

  16. Sarah in Iowa says:

    Hi Ron,
    I know all about insurance, since I am a licensed insurance agent :)

    Maybe it is different in your state (although I am pretty sure not), but in the 13 states I am licensed in, there is never a deductible for liability. There would be the deductible for fixing my own car, but that’s not liability. And the scenario made it seem that it was the other car that was damaged, not mine, so we would be talking about liability.

    I do understand that reporting the accident to insurance might cost you more in the long run in the form of higher premiums. By the way, although your agent told you not to claim the accident, you should probably check your CLUE report to be sure it’s not sitting there as an opened claim with a $0 collision payout. If you ever go to switch carriers, the new one will check CLUE and will quite possibly list that as an at-fault accident because it is reported, and collision indicates you were at fault. Yes, regardless of the fact you paid it out of pocket. Food for thought, huh? You may be able to get your current agent to take it off the report, but of course you’d want to do this now, while you’re still in good standing with each other, not when you’re trying to leave later :)

    I agree with GregK re: Jonathan’s zinger. I, too, thought Anonymous was a hilarious little troll :-)

  17. ended the month with $1158 in this game. not bad. 2 years straight and i’ll have 24,000!

  18. @ Sarah: Thanks. I need to talk with my agent. We never officially reported it, at least through insurance, just got an opinion from her on whether to report it.

    As for the deductible, thanks again. I will check my policy tonight. We do have liability coverage on all cars. I had in my head that my current state has a deductible there as well.

  19. Sarah in Iowa says:

    No prob, Bob. I mean Ron. :)

    I hate being the one to break it to people that their agent opened a claim when they called to ask a question like that. Much better that you find out beforehand if it’s there and get rid of it.

  20. Reading the fear mongerers says:

    Jon,

    Speaking of emergencies: what’s your take on the potential for the “dollar collapse”, and the dollar to be removed as the reserve currency for nations abroad, particularly in Asia? While I am concerned about these things, I do not know how likely the scenarios are, and how much my concern should dictate alternative financial planning (investing in gold/silver; abroad, on foreign markets, etc). I am curious on your thoughts, as I know some intelligent people personally, who believe these scenarios are imminent (1-2 years out).

    Thanks,

    JJ

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