The conventional wisdom from personal finance experts has always been that people should build a very large emergency fund of varying months of coverage — usually either three months or six months of after-tax income is recommended. Some people even call for a full year. I say this advice is too broad and has many drawbacks worth considering. Far be it from me to suggest that people should live paycheque to paycheque, but I want people to realise what they’re sacrificing when they adhere to such a rigid emergency fund requirement, especially when it takes considerable time and sacrifice to build a fund that large.
- You’ll Put Off a Home or Large Goal Forever – If you’re already living paycheque to paycheque and barely making enough extra money to put a little aside each month, it may take several years to finally build up a large amount of savings. Now that savings could be used for anything from a down payment on a flat to a business investment to taking that trip you always wanted to. But instead, it just sits there. While you have the peace of mind in having that large fund set aside, you forgo other things in life that might have been worthwhile.
- Better Off Invested for Retirement? We all know these days that money residing in a low-rate ISA or other safer cash accounts are actually losing money to inflation. But in order for savings to be considered for use as an emergency fund, they have to be liquid and safe. But by forgoing investing in asset classes like stocks and bonds which have higher returns over time, you’re leaving considerable money on the table over a lifetime. This could mean thousands upon thousands of pounds in lost opportunity over a decades-long period.
- Paying High Interest Debt While Losing Money in Savings – Some people focus so much on building an emergency fund that they continue to pay off higher interest loans while continuing to build an emergency fund. This is a net loss from a cash-flow standpoint since the money would be better spent paying down debt.
- Life Will Pass You By – While you may be living a more stress-free life by having a large cash hoard to fall back on, is life passing you by? We take risks every day. Each time you leave the house you’re taking a risk, but we still do it. You need to live too. By focusing all excess funds solely on building an emergency fund, you may be missing many of life’s great experiences.
There are various alternatives to having a pure cash-only emergency fund. If you have multiple sources of income or don’t mind investing in stocks, you can use funds from these sources in an emergency. Likewise, in a rapid jam, you could always use a personal loan to cover immediate needs and then tap your less liquid assets if the shortage continues. In summary, there are many alternatives to living under the requirement of strictly building a huge emergency fund while forgoing much of what life has to offer.