Do you have an emergency fund? If so, you’re likely incurring emergency fund hidden costs.
Essentially you’re paying a cost for holding that cash in case of an emergency.
There are three emergency fund hidden costs of holding cash in an emergency fund.
Most personal finance experts recommend having an emergency fund for unexpected life expenses.
Traditionally, most emergency funds are recommended to be held in a savings account so that you can easily access the money if needed.
But, most of the personal finance gurus don’t talk about the hidden costs of holding cash in a savings account.
What are these costs?
- Inflation
- Lost Potential Investment Returns
- Extra Interest Expense If You Have Debt
Cost of Inflation
Inflation is known as the price of stuff going up over time.
Here’s the Merriam-Webster official definition:
A continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.
The federal government even tracks inflation but it’s much more complex because it includes all kinds of stuff and takes into account technological improvements.
What’s more important to you is how the prices of the stuff that you buy consistently are rising.
One day your latte is $3.59 and the next day your latte is $3.79.
That’s inflation.
If you buy one latte a week, that’s an extra $10.40 per year.
That might not seem too bad but it’s actually a 5.5% increase in the cost of the drink.
If you spend $30,000 each year on common purchases (toothpaste, food, RENT, etc.) and your personal inflation is 5.5% it means that next year you’ll be paying $31,650.
When you hold cash that
Let’s use the example above for your emergency fund but let’s say your personal inflation is closer to 3% and you want to have an emergency fund of one year worth of expenses.
Here’s the break down of how much you would need in your emergency fund:
- 1st Year: $30,000
- 2nd Year: $30,900
- 3rd Year: $31,827
- 4th Year: $32,782
- 5th Year: $33,765
- 10th Year: $39,143
So, after 10 years you need over $9,000 more just to cover your annual living expenses.
If you kept just $30,000 in the account, you would only have enough to cover a little over 9 months of expenses.
Unfortunately, it’s difficult to know how much inflation will affect you personally.
So, how do you combat inflation so that your money doesn’t lose its value?
You invest it.
Lost Investment Returns
Your cash (also known as your capital) always comes with an opportunity.
You have a few options:
- Spend It
- Pay Off Debt (Repay Past Spending)
- Invest It
- Hold It
- Give It Away
You could burn it or throw it away but those are dumb options.
The cash that you earn creates opportunity.
This is one of the keys to a wealthy mindset.
What is that opportunity?
To spend less money or to earn more money.
We’ll get to spending less money in the section on debt.
For now, let’s discuss the ability to earn money with your money.
When you have cash, you have the opportunity to invest it and turn your money into more money.
In theory, the riskier the investment the higher the return or larger your money will grow if everything works out.
You could also lose all or some of the money if the investment goes bad.
Still, when you don’t invest it, you are losing out on that opportunity for a return.
An Example
If you have the opportunity to buy corporate bonds yielding 4% and you don’t, you are foregoing that 4% of growth.
You may be foregoing it because there is a better investment option or you may be foregoing it because you want to use the cash for something else.
It’s important to think about this emergency fund hidden cost because you may be holding that cash for a long time.
Let’s say you can invest in a 5-year high-rated corporate bond at 4% or hold your $1,000 in an emergency fund.
Each year you receive $40 (minus any taxes) for holding the bond, which you can reinvest.
Meanwhile, your $1,000 may be earning anywhere from 0.00-2.00% in a checking or savings account.
At 2%, that’s around $20 a year with essentially no risk. Not a bad deal.
But, over the course of 5 years, the difference ends up being $100 ($40 x 5 – $20 x 5) which is pretty big on a $1,000 investment.
And, this doesn’t factor inflation.
If your personal inflation is 3% each year, the return on the corporate bond effectively becomes 1% each year while holding your cash in a savings account becomes NEGATIVE 1% each year.
The fact is that every dollar that you can put towards retirement or building wealth, the larger it will grow.
Over 5 years it might not seem like much but take an investment that grows 5% annually for 30 years.
Due to compounding, a $10,000 investment will grow to $43,219 in 30 years.
And, for comparison, a $10,000 emergency fund in a 2% savings account would grow to $18,114.
Extra Interest Expense If You Have Debt
If you have debt then you’re paying interest, likely each month, on that debt.
If you need help figuring the cost of your debt, check out our post:
How Much Money Does Your Debt Cost You Each Day?
When you also have an emergency fund in combination with debt, you’re essentially paying to hold that cash.
Why is that?
You could use that cash to pay down at least some of your debt and no longer pay interest on that portion.
If you have $10,000 of debt and the interest rate on the loan is 5% then your monthly interest payment is going to roughly be $41.67 next month.
For a $1,000 emergency fund, you’re paying $4.17 each month in extra interest to have that emergency fund.
And, the thing is that there is a compounding nature to paying off the debt sooner.
You make a $1,000 payment on your 5% interest rate debt and next month you pay $4.17 less in interest.
Here’s the math on that:
5% divided by 12 months multiplied by $1,000 equals $4.17.
Now, $4.17 doesn’t seem like much but if you’re making the same monthly payment amount each month, that $4.17 is now paying off the balance instead of paying off the interest.
This creates a cycle of more money going towards the balance faster which helps you pay less interest overall and pay off the debt faster.
If you have debt, you have to be aware of the emergency fund hidden cost of extra interest that you’re paying each month.
Final Thoughts
What would you do with that money if you were not saving it for an emergency?
If you want an emergency fund, it is your personal choice.
It will likely provide you will some feeling of security in regard to your finances.
It might even help you if you face unexpected expenses.
Here another post we have about emergency funds and planning for financial emergencies:
- Should You Have an Emergency Fund?
But, emergency funds do come at a cost.
You should be aware of th
Ask yourself, could I put this money into an investment or pay off debt?
How much would you expect the money to appreciate each year in an investment?
And if you have debt, how much would saving by putting the money towards debt?
While an emergency fund will help you if you face financial hardship, you may be hurting yourself financially.
Think about it like insurance.
The hidden costs of the emergency fund is the premium that you’re paying on the insurance.
Insurance helps to reduce risk and help us sleep at night but it still comes at a cost.
You have to ask yourself what is the right balance for you based on your situation.
