We all know the importance of having an emergency fund. Should something unexpected happen, we can take the stress that is related to it in terms of finances out of the picture and spend our energy focusing on how to get through the difficult times. But in the low-yield environment that we are living in, many people are looking for options to boost the return of their cash. Many have turned to investing their emergency fund. Is this a smart move? What are the advantages? What are the disadvantages? I cover all of these below, helping you to make the best choice for your situation.
Why Invest Your Emergency Fund?
With interest rates hovering at virtually 0% for most savings accounts, the cash in your emergency fund is losing out to inflation every day. While this may not seem like a big deal today to only be earning 0.05% on your money, over the long-term it makes a sizable difference.
With inflation averaging 3%, goods and services increase in cost by that 3% per year. This means that the $100 you pay for groceries this year will cost you $103 next year, all else being equal. If you aren’t earning a return on your money, that’s $3 less you have to save or spend elsewhere. And this amount compounds each year.
The next year it will be another 3% increase for a total bill of $106.09. Then $109.27 the year after that. You get the picture. And this is for all goods and services too, not just groceries. So, the question comes down to should you or should you not invest the money in your emergency fund to earn a higher return?
Unfortunately, the answer is not a simple yes or no. It is actually more complicated. Let’s first look at the advantage of investing your emergency fund.
Advantage of Investing Your Emergency Fund
Right off the bat, the clear advantage to investing your emergency fund is to earn a higher return. With stocks, over the long-term you can expect to earn 6% per year, using a conservative estimate. With bonds, you are looking at closer to 4% per year, again using a conservative estimate.
It doesn’t take a genius to see that 4% or 6% is much better than 0.05%. Sadly though, this is the main benefit of investing your emergency fund.
Disadvantage of Investing Your Emergency Fund
We all know that risk and return are related, right? Well, to get that higher reward by investing your money, the risk is that you can lose money. This goes against the whole idea of an emergency fund in the first place. You have money in your emergency fund so that you can pay for unforeseen events in your life. If you lose that money when the stock market drops, how are you going to pay for those unforeseen events? Most likely, with your credit card and nobody wants to do that.
What Is The Answer?
When you take everything into account, for most people, just keeping your money safe in a bank account is the best option. You can do better than 0.05% by moving your emergency fund to an online bank, many of which pay closer to 1%. While it still doesn’t keep up with inflation, it is better than earning virtually 0%.
Another option is to put your money into certificates of deposit. Again, you won’t earn a huge return, but you will do better than most banks savings accounts.
The reason I suggest keeping your money in cash is simple. You have quick and easy access to it and it will be there 100% of the time should you need it. Yes interest rates are super low right now, but they won’t stay this low forever. You can take the short-term “hit” of earning low interest on your money now and earn a decent amount more when interest rates rise, which is expected later this year.
Don’t fall for the glitz and the glamour of earning a high return on your emergency fund. Remember what its purpose is – to pay for things in the event of an emergency. It is not designed to grow quickly so that you can retire on it or to fund your child’s college education. Those long-term planning events should be invested in the stock market where it makes sense to take on the added risk.
But not your emergency fund. It is supposed to always be there for you. I know it’s boring, but having all your money earn a little interest is better than potentially losing some of your money and earning some extra interest. Don’t chase returns with your emergency fund. Let it do its job and you do yours by keeping it safe.