Should Your Emergency Fund Be $0?

Topics and your questions answered on the show

• Someone challenges me on how to fund an emergency.
• Stefanie says her family is telling her home warranties are a good idea.
• What is financial freedom looking like to you?

Should Your Emergency Fund Be $0?

Scott A. T.: Broadcasting from One Dallas Tower, welcome to the “Financial Rock Star” show. I’m your host, Scott Alan Turner, ready to help you get out of debt, save more money and retire early. In the studio with me is Producer Katie, who finally has given in and says I can get a new tattoo. I’m very excited. On the show today I’ll be answering your questions about money, business and life. If you have a question you’d like answered on the show, visit Goaskscott.com.

When I bought my first house, I had a first mortgage and a second mortgage because I only put 5 percent down. I drained my entire bank account to cover the closing costs. I had a big car payment and no savings. Not a good situation to be in. What would have happened if a week later I had lost my job and not been able to make the mortgage payment? Where was that money going to come from?

What would happen if a week later we had a big hail storm come through and I needed to get the roof replaced because it was leaking, and I didn’t have any money? Kind of like my house right now. We just had a hail storm come through. I’ve got to shell out $10,000 to get a new roof. It’s an emergency, an unexpected cost situation that I was not expecting to happen.

Well, someone called one of my ideas dumb, so of course they go to the front of the line. Now, I don’t take it personally. I don’t take it personally. Some people occasionally drop me nastygrams with a lot of swear words. That’s not very nice, but this person is just saying the idea is dumb. Well, is it? Let’s take a look.

The topic is what is an emergency fund and why you must have one, an article on my website. My stance is you should have three to six months of funds in liquid assets like cash to cover expenses, like if a hail storm comes through or your car breaks down, you have a job loss, a loss of income, an unplanned pregnancy, a medical emergency where you can’t work. In that particular article, I use the number $2,500 to save up in cash before you start attacking debt. We’ll get to that in a minute.

I’ll be the first to admit if something I say is inaccurate, incorrect, flat-out wrong or if I change my mind on something. As an example, if you go back to early episodes of the show, I was very adamant about always paying down student loans ASAP, at the cost of everything else, even investing. As I reviewed more and more personal situations, my ideas kind of changed a little bit regarding that.

Likewise, if someone else is giving out inaccurate, incomplete or flat-out wrong information, I’m not going to hesitate to bring that up as well. I’ve never claimed to be the smartest tool in the shed, the sharpest tool, the brightest tool in the shed, but if you decide you want to enter the squared circle for a financial smackdown, you’d better have a roll of quarters hidden in your fist to punch with, because you’re going to go against the total package, Lex Luger. In the words of The Rock, don’t sing it, bring it.

In today’s breakdown, we’re going to tackle the emergency fund. Here’s a quote from the comment. “In our financial plan,” the person who wrote this, “you will never find one staple item that every so-called financial planner calls the cornerstone of your responsible financial plan, the emergency fund.” Stop. We’re going to stop right there and address the first sentence.

Let’s stop and address the “so-called financial planner.” This person is referring to people who dole out financial advice for a living, and happened to include me in the list. First, I’m not a financial planner, nor have I ever claimed to be. I provide information. You decide what you want to do with it. What do the not-so-called planners have to say, professional financial planners? Oh, how about Certified Financial Planners, the people who go and have to do three-year internships, go to school thousands of hours of study, be cream of the crop? Well, I should know because I’m enrolled in the master’s program and I have the textbook right in front of me.

Page 59, “College of Financial Planning, Introduction to the Financial Planning Process.” Quote, “The emergency fund, how much? It is recommended that individuals retain a sufficient amount of liquid assets at all times to handle emergencies, so they will not have to borrow money or liquidate investments at a potentially inopportune time. However, because investments with the greatest liquidity tend to have the lowest earnings, it is important that the amount that is held out for an emergency fund is not excessive. A good rule of thumb is that the client should have the equivalent of three to six months of fixed and variable expenses in liquid accounts for emergencies. This would exclude the expense of income-related taxes and contributions to savings and investments, like a 401(k).”

It continues. “Where did this rule of thumb come from? From a theoretical point of view, the worst emergency is where a client loses his or her income due to the loss of a job or disability. If the individual is not earning an income, income taxes won’t be paid. Likewise, if there is no income, the client will not be adding to savings and investments. Rather, he or she will be drawing on savings and investments. This rule of thumb came about prior to pre-tax medical premiums, flexible spending plans and a host of other that are not incorporated into this calculation,” end quote from the book. Okay, so the guys who wrote the book on financial planning say to have an emergency fund. I will take their word over anyone else’s.

I could stop there, but I want to address the other points from this person’s comment. Ding-dong. Somebody just rang the office door, but I can already tell this segment is going to go long. It is what it is. Continue on with the quote. “Not that we are so strapped that we couldn’t afford an emergency fund. Our net worth is solidly in the seven figures and north of 30 to 35 times our projected retirement spending budget.”

This is the person writing this comment here. “We never had an emergency fund and never plan to have one. That doesn’t mean that we never have unexpected spending shocks. If we do need cash, we’ll get it out of our vast supply of, quote, `emergency cash,’ which is in exactly that order,” and he says, “Our emergency fund is exactly $0.”

Here’s where they’re going to get the cash from. “Number one, credit card float, an interest-free loan from the credit card company between the transaction and the credit card payment due date,” so the 30 days while the credit card bill is hanging out there. “Number two, our paychecks. Number three, a $100,000 home equity line of credit on our condo, and number four, finally a large sum in several brokerage accounts, more than half our liquid asset net worth.” Remember this person has a seven-figure net worth. End of quote right there.

I am happy that you guys have a plan that works for you. However, you’re in a very small minority, and you’re trying to apply your plan that’s specific to your situation to the majority of people who, A, have no savings, B, are living paycheck to paycheck, and C, have $15,000, on average, in credit card debt. The average person has no savings.

According to Bankrate.com, “Thirty-seven percent of Americans have enough savings to pay for a $500 to $1,000 emergency. The other 63 percent would have to resort to measures like cutting back on their spending … that was 23 percent of people … charging to a credit card … 15 percent of respondents … or borrowing funds from friends or family … 15 percent of respondents … in order to meet the costs of an emergency.”

It goes on from this survey. “$500 is enough money that it could be catastrophic if you are literally living on the edge and don’t have enough money to cover an unplanned expense.” According to Bankrate’s senior investing analyst, Sheyna Steiner, I think, who said in a phone interview, “I did wonder what would happen if it was $10,000. What would the answer have been then?”

The article goes on. “A $10,000 emergency is a somewhat rare occurrence for families of moderate income, but it’s hardly unheard of. According to the Pew Charitable Trust’s analysis, the median size of a family’s most expensive financial shock, as they called it, in a year, is $2,000.” So if you want to know where I pulled $2,500 out of for that article I wrote, there you go, Pew Charitable Trust analysis.

Let’s break down your four sources for your emergency fund of $0 that you have. First you have credit card float, 30 days to borrow the money. That assumes you have the money to pay it back, which people don’t, because we just gave the stats. They don’t. You do. Great. I’m very happy for you. The majority of people do not, so let’s just scratch that off the list for the majority of people that cannot pay it back in 30 days.

Number two, paychecks. An emergency fund, you have to prepare to not have a job. Talk to someone who’s been out of work for six months, or 12 months. I have a friend who just got a new job offer after looking for work for 12 months. This is a reality. People will lose income if they lose a job, and they may not get a new job quickly. They may not have two incomes. I had a single income when I had my home mortgage. There was no other person giving me an income, so let’s scratch that off. We’ve got to prepare for not having income.

Number three, using a HELOC. I’m not going to exchange unsecured debt on a credit card for secured debt on a home. I can say, “Screw you, credit card companies, I’m not going to pay you.” I can’t say that to the mortgage company. They’re going to come and kick me out of my house. I don’t think that’s a good option.

Number four, investments. You have completely missed the mark on an equity portfolio. If I have $100,000 in stocks, in 2008 and 2009 the market dropped 50 percent. If I’m about to replace my roof and it’s going to cost me $10,000 … like I have to right now … it’s an emergency. I have hail damage. I need a new roof. If I had to pull it from my equity portfolio in 2009, my $100,000, which became $50,000, is now $40,000. A 50 percent drop, sell $10,000 to cover the roof, that’s $10,000 that is not going to grow anymore, or recover or compound.

You never know when stocks are going to have a run of one, two, three, ten down years. It’s those years, when they happen and you need the money, you’re forced to sell at the worst possible time. Everybody wants to make a bigger return and more money on their investments, but what is the risk? I will gladly give up a little upside … meaning not having that money in the stock market … in order to protect myself from the downside. When there are market dips, I don’t want to sell in those downsides.

Let’s continue on. Quote, “The main reason against having an emergency fund is opportunity cost. Back in the old days, financial planners recommended three months of expenditures, but that was when money market accounts actually paid interest. Suze Orman now recommends having eight months’ worth of cash, earning half a percent interest per year before taxes. By the time we need that emergency cash, an equity portfolio would have already doubled to 16 months of expenses. If you have a substantial amount of savings, who needs an emergency fund?” End quote.

Wrong. I quoted the textbook above. It was updated in 2005. It still says three to six months, and interest rates had been at zero long before that book was published. This is not back in the old days, financial planners recommended this. This is last year when this book is published, financial planners recommended this. This is not anything new. This is not anything that’s changed.

Next part, “Another example that shows the total and utter irrationality of the so-called financial adviser community is the recommendation to start an emergency fund even before paying off your credit card debt, which is the pinnacle of financial illiteracy. The quote/unquote `logic’ is that … and I quote from the last resources above … `having an emergency fund in place is going to keep you from taking on more debt when an emergency hits.’

“An analogy of this idiocy would be this. A fire truck arrives at a burning house. The truck carries enough water to distinguish this fire, but instead of fighting the burning fire … the equivalent of 15 percent interest eating your future … the truck waits for a second fire truck to show up … saving in the emergency fund … for fear of running out of water, just in case there’s a second fire somewhere else in the neighborhood. How dumb is that?” End of quote.

Hey, if people were smart and math were the only issue, nobody would be in debt. This isn’t a math equation, it’s behavior. Most people have never had $1,000, $2,000, $2,500, saved up in their entire lives. They might be 40 or 50 years old and for the first time have some cash, and it’s empowering. It’s not math. If it were math, we would say, “Sell everything, get a fleabag room in crack town and get out of debt.” Nobody does it. It’s about power and momentum and changing behavior.

That seed money is the catapult for change, and people can get that quick win in those 30 days by going all in and selling some stuff and getting that little reserve over there. That little interest hit by saving cash and not paying down debt, it’s insignificant to the mental win of having some money. You can’t get out of debt by taking on more debt. That’s why that little bit of money is there. It’s psychologically proven. It’s not math. Thinking math is going to get you out of debt is dumb, because if it were math, for most of us, we wouldn’t have got into debt to begin with. I certainly wouldn’t have, and the 50 percent of people who carry a credit card balance wouldn’t either.

Next quote, “The logic is that … and I quote from the last resources above … `having an emergency fund is going to keep you from taking on more debt when an emergency hits.'” Is it’s not only logic, it’s fact. If I have $1,000 in a savings account and I need a new alternator, I pay for it in cash. My credit card balances remain the same. I’ve taken on no new debt. I’m not paying more interest charges on the new debt. That is a fact. I’m given a little psychological boost which keeps me going, which gets me out of debt faster, despite the slightly more in interest I’ll pay in the time it takes to replenish my emergency fund. It is not a math fact, it is a behavior fact.

I’ll give you another example. Is it idiocy to pay off a 4 percent mortgage when you can earn 8 to 10 percent from investing over 30 years? Mathematically it’s pretty stupid. I can prove it on paper. I could have a couple extra hundred grand, a million, 20 or 30 years from now. I don’t know, but nor do I care, because to me, I’ve invested in my sanity and my freedom, which have a cost which I cannot put on paper. It’s not measurable on paper, but I have a pretty worry- and stress-free life, because I have no mortgage and I’m 100 percent debt-free. I guess you can call me an idiot then, and dumb, but I like my life. I like the freedoms and no mortgage, and that is worth more to me.

Here’s the final quote. This is going to end up being the entire show. We’re not even going to get to this in time. “What if something does go wrong and we need the cash? We use a credit card with the longest interest-free loan at zero percent. By the time the credit card bill is due, we have likely gotten income to pay off the credit card bill. If it’s too large, we use the HELOC. We might pay a little interest in the HELOC mortgage. So far, we’ve never needed to sell investments to cover costs, but if we have to, we will hold in cash has grown so much that the dividends can cover the cost.

Health insurance costs are low out of pocket. If we lose our jobs, we’ll have enough money to retire. Our employer has a generous long-term and disability plan. We live in a condo where big-ticket repairs are covered through the homeowner’s association.” Well, that’s nice. “Not a single thing inside our home we can’t replace for $1,000. Why do we need eight months’ worth of salary sitting around idle for that?

“If the reasons above weren’t enough, the entire idea of an emergency fund has one additional fatal flaw. If you are really serious about your emergency fund, right after spending on an emergency event, you’d have to replenish that fund back to eight months of expenses, right?” That was the final comment.

You see, while your situation might work for you like this person’s situation might work for them, applying your advice to everyone else in every situation is, in your own words, dumb and idiocy. Bottom line, while this person’s comments work for their specific situation, it’s not what I would recommend doing. It’s not what I do. It’s not what the College of Financial Planning teaches to their students. I could have a HELOC. I don’t. My homes are paid for. I could pull money out of my investments, but I don’t. I never know when the market is going to go down. I could apply for a zero percent-interest credit card, but I’d be taking on debt. I don’t like debt. I like feeling debt-free and being debt-free.

Let me retort and tell you what I think is dumb. I think it’s dumb to portray someone else’s advice as dumb and idiocy just because you disagree with it. I think it’s dumb to provide advice that works for someone with a net worth of over $1 million to someone that is broke or $100,000 in debt. I think it’s dumb to throw out advice without doing some fact-checking.

I would argue it’s irrational and dumb to have home insurance in case your house burns down, and life insurance, because the chances of your home burning down or you dying are so small. It makes more mathematical sense to not pay either of those premiums and invest the money instead, because chances are you’ll come out ahead.

If you take 100,000 people and tell them all, “Don’t pay your homeowner’s insurance, invest the difference,” equal to their premiums, most of them are going to come out way ahead, but a few people are going to be bankrupted when the house burns down. On average, most people are going to be better off without homeowner’s insurance. There is a higher return by not paying for insurance, but is it better? Well, it’s riskier.

I’m not saying go out and cancel your homeowner’s insurance. I don’t want to be subject of running that risk, if a fire burns down my house and I don’t have coverage on my home, compared to investing the proceeds on my own, which are likely to have a higher outcome. The downside is I’m going to lose my house, and that is going to be … that’s going to be a problem for me. To me, not having homeowner’s insurance, although it’s probably mathematically better in the long run, if there’s an emergency and my house burns down, that doesn’t work for me.

You could say the same thing of funding your unemployment with credit cards. Too risky. Funding an unplanned pregnancy with a HELOC? Too risky. Funding a medical emergency, a loss of income, with your investments in a down market? Too risky. You might have heard, if you want to be rich, you do what rich people do. Well, that statement is a recommendation you follow the common themes that run through rich people’s lives, that they use to build and keep wealth. If 10 percent of rich people smoke cigars, it doesn’t mean you should smoke cigars. If 2 percent of rich people invest in hedge funds, it doesn’t mean you invest in the hedge fund. If 70 percent of rich people budget, probably a good idea that you budget if you want to become rich.

Does doing what I do matter? No, absolutely not. It’s what works for me, makes sense to me. This other person’s plan, is it wrong? Nope. It’s what works for them, and they are happy with the level of risk they’re taking. What about their advice? My opinion, it’s not practical for the majority of people because of their financial situation, and so what I would say is too much risk with not enough upside for most other people. It’s not what a Certified Financial Planner would recommend to you. It’s not what the so-called financial planners would recommend you do either.

Your emergency fund could be, in the worst-case scenario, “Hey, we both lost both our jobs. We’re just going to walk away from everything, the house, the cars, all the bills and everything. We’re going to go get an awesome cardboard box down from Lowe’s, put it under the bridge, and we’re going to live there for a while and we’re okay with that.” Hey, that’s a personal choice. It’s not my plan. It could be yours, but I’m going with what I found to be beneficial to me 16 years ago now when I had debt. I’m going with the advice I recited straight from the College of Financial Planning. They’re smarter than me. They wrote the book. If I disagree with the book, I’d better have a wide body of proof and research to dispute it. On this particular issue, I do not.

I thank the writer for the topic of the argument. I love a challenge. I love a debate. I hope you guys learned something from that. It was fun. It was fun. Please feel free to send me your comments, what you agree with, what you disagree with. This is what makes personal finance personal, because every person, every situation, is unique. What works well for somebody might not work well for somebody else.

That’s why it’s important for everybody to not take what someone says as the gospel truth. Do your own research. Ask questions, read books, see what works and doesn’t work in your own life, and make an educated decision. Go down a certain path, and if you find that path is not working for you, re-evaluate and decide was the plan that I decided to follow urgently wrong, or am I not following the plan as it was intended to be followed? Is that the problem?

If you have a question you’d like answered on this show, if you’ve got a topic you want to debate about, if you want to call some of my advice dumb or idiocy, the website is Goaskscott.com. Or if you’ve got an awesome hamburger recipe you want to share, the same website.

That was not me on the guitar, but I have been practicing what is essentially a six-minute guitar solo in this song I’m learning for the band I’m in, for the show that we’ve got coming up in a few weeks. It’s exciting.

Stefanie: Stefanie says her family is telling her home warranties are a good idea. Some people will swear by them, but they are in such a tiny minority. The stories you might hear are from the rare few who got something covered by a home warranty. A home warranty is a cash cow for the companies that sell them. They come with so many gotchas and exclusions that they really aren’t worth the paper they’re printed on.

Scott A. T.: They limit how much they’ll cover. You can’t choose the contractor, which means you’re always going to get the cheapest contractor who shows up at 7:00 at night when they say they’d be there between 12:00 and 2:00. You pay for the labor. Some of the parts might not be covered. It’s a big waste, and I can prove it’s a waste with … da-da-da … math, simple math. We look at simple math when we’re making decisions sometimes.

If you own a home for 30 years, you paid $500 a month for a home warranty, that would come out to $15,000. The odds of you needing multiple repairs over a 30-year period that would fall under a home warranty and cost you more than $15,000 are about as good as you winning the lottery. You have to have a real lemon of a house to have that much stuff break over 30 years that would fall under a warranty situation.

I’ve been a homeowner for 17 years now. We had our air conditioning break at Katie’s townhouse. That was $3,000 to replace, and one here at my current home a couple of years ago that was $1,500 for repairs. So if I’d paid $500 a year for 17 years, that’s $8,500, and I paid $4,500 out of pocket for those two repairs. Thus far I have saved $4,000 by not having home warranties each year. The idea is to self-insure, and you do that with your emergency fund, however you want to fund it, which we just discovered in depth.

Yeah, something’s going to break in your house someday. That’s just … that’s going to happen. The A/C, the fridge, the washing machine, the garage door opener, water heater first, whatever, but you are going to save so much money by just paying out of pocket rather than for these warranties. Remember when you do the math, those companies are not going to cover 100 percent of the cost. It’s going to be some of the parts, or none, or slightly more than none of the labor, and it’s with the contractors that they pick.

You’re paying the yearly fee, $500 or whatever, and on top of that, money out of pocket to get the problem fixed. It’s always going to be more than the $400 you’re paying. Don’t waste your money, Stefanie. You work too hard for it. I realize some people you’re going to find are going to say, “Yes, I’ve had a home warranty and it saved the day.” That’s a rarity, not the norm.

Scott A. T.: Today … meaning the day that I’m recording this … I got home around noon from the gym, covered in sweat. I walked into my office to do something and Bram walks in to me, says, “Daddy, we’re going to the pool. Will you come with us?” He’s two and a half. I thought for a second, “If I go to the pool, it’s basically going to torpedo the rest of my day,” because I was already behind on my self-imposed schedule and I had a lot of things I wanted to get done that afternoon.

I thought, “You know what? I am going to go to the pool with you. I’m going to put all this other stuff aside and I’m going to make spending time with you a priority, because I know these moments are not going to be here forever, in the middle of an afternoon in the middle of a workday, when you’re small and tiny and you come to me with that cute little voice of yours and say, `Will you come to the pool with us,’ because you don’t know about work, you don’t know about any other thing in life, you just want to spend time with Mommy and Daddy.”

I share that with you because this is the definition of financial freedom. It’s what all those tiny little sacrifices are for that you make, all the skipped meals, the debt down-payment, the savings for early retirement, whatever you’re doing, the selling of the car that you paid too much for because you made a mistake like I did in the past.

Whatever it is, the sacrifice, the little things, the day after day, the minutiae, the annoying stuff, the things you can’t stand, it’s for this reason, so that when the opportunity, when the activity or whatever it is comes your way, you can stop for a second and say, “You know what, I will do that. I will forget about whatever we have planned, I’ll forget about whatever I was going to do, because I’ve got that financial freedom. I’ve got that opportunity fund saved up,” whatever it is, whatever that means to you. I share that not to say, “Oh, look at me, look what I get to do, go swimming in nice cold water in the afternoon with my kids.” It’s to encourage and inspire, and say, “This is what it’s about.” Those are the words.

That’s it for this episode. I’m your host, Scott Alan Turner. Rock Star Katie is my producer. All the links mentioned in this show are available in the show notes on … oh, wait. There were no links today. Never mind. Never mind. All the links we didn’t mention today are not in the show notes, but there are show notes with a transcription if you want to go read it. If there’s a question you’d like answered on the show, visit Goaskscott.com. Thank you so much for listening.