We may think of an emergency fund as being the safest of all savings vehicles that we have. That of course is what an emergency fund is supposed to be – but it isn’t always, at least not in reality. There are certain threats to your emergency fund, that have the potential either to lower the balance, or even wipe it out completely for purposes that have nothing to do with the reason why it was set up.
Using it for “emergencies” that aren’t emergencies
When you start an emergency fund, you have to be absolutely clear on the definition of an “emergency”. A job loss certainly constitutes an emergency situation. A medical emergency is another. The furnace breaking down, or a major car repair bill would be others.
But there sometimes are reasons why you might tap into your emergency fund for situations that while important, don’t necessarily rise to level of an emergency. For example, you may take money out of your account at a time when you’re simply short of cash flow for the month. You might withdraw money to pay for a relatively a small car repair bill. Or you might even tap it to help pay for a vacation or for holiday expenses. Those expenses may be large, and even infrequent, but they’re not emergencies.
If you get into the habit of drawing money from your emergency fund for expenses that are less than emergencies, the fund effectively loses its primary purpose and becomes a general resource. Should this happen, it will be just a question of time before your emergency fund will disappear completely.
Set clear boundaries as to what an emergency is, and what it isn’t.
Lack of financial discipline
Sometimes an emergency fund is built not through regular savings contributions, but from cash windfalls. It’s perfectly okay to stock an emergency fund from a tax refund, a bonus check for the proceeds from the sale of an asset, such as a car. But if this is the typical way in which you stock your emergency fund, you may not have developed the discipline that comes from making regular contributions.
Regular contributions require that you get into the habit of restocking your emergency fund on a regular basis. You will withdraw money from the account as emergencies arise, so it’s vitally important that you have a way of systematically replenishing what is taken out. That doesn’t happen if you fund the account from a cash windfall.
Discipline is important in all areas of finance, and that includes an emergency fund. But if discipline isn’t what enabled you to fill your account in the first place, you may not have it when it comes to managing the account either.
That discipline requires not making withdrawals from the account short of a bona fide emergency, and a system for replenishing the account on a regular basis.
Investing your emergency fund
Ideally, an emergency fund should be sitting in nothing more fancy than a savings account or a money market fund. However, with rates on these accounts running well below 1% per year, people begin to think about investing their emergency fund in something with greater returns.
Your emergency fund doesn’t exist to earn higher returns. It’s sole purpose is to sit in a completely safe place so that it will be there anytime you have an emergency. While looking to earn more on your emergency fund may seem like a noble pursuit on the surface, anytime you increase return, you also increase risk. Risk is something that should never be associated with an emergency fund.
When it comes to your emergency fund, learn to be content with safety first and foremost.
Perhaps the biggest threat to your emergency fund is a spending spree. We already talked about tapping the fund for non-emergencies, such as vacations and holiday expenses. Sometimes financial order can break down, and when it does all resources become fair game. That means credit cards, new loans, and yes, even emergency funds.
The last thing you ever want to do with an emergency fund is to drain it on frivolous spending. But it’s easier to do this thing you think. Even if you’re normally quite disciplined when it comes your finances, a period of high stress can easily send you into a spending spree. This can include unusual stress on the job, potential health issues and even conflicts with other people.
Whatever else you do, your emergency fund must be absolutely closed to spending sprees. A single spree lasting only a few days can easily drain an entire emergency fund.
What steps do you take to protect your emergency fund from these and other risks?