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Misidentifying emergencies often leads to emergencies

First appeared in USA Today and The Indianapolis Star

Dear Pete,

Right now, we leverage an online savings account to earn a little interest for our emergency fund. I am conflicted on what to do with this money. Most of the time, I really don’t want to put this money in the market, because it is more a feeling of comfort to know the money is not subject to the ups and down of the market. At the same time, I occasionally feel like I want more yield than a savings account. What’s your philosophy on emergency funds and risk?

— Jason, Lansing, Mich.

When I was in second grade, my grandfather and I were out having lunch. As he pulled out his wallet to pay, I saw a $100 bill nestled in a small slit in his wallet. “Whoa!” I exclaimed. “Where’d you get that, Papa?”

“That’s for an emergency,” he offered somewhat sternly. “I’ve had this in my wallet for years — just in case I get into a situation I can’t get out of — without using it.”

This moment has been etched in my brain for the better part of 32 years. Not only is it the basis for understanding emergency funds, but also is the answer to your question, Jason.

Just think how often my grandfather was at a store or restaurant or any other place with sirens that sang for his C-note. Not once did he reach for the hundred-dollar bill.

People struggle to define the term emergency, as it relates to money. This is where the problems often begin. At one time in our culture, the word emergency had a connotation which summoned images of pain or suffering. Today, financial emergency can easily be used to describe blowing off steam or scratching the impulsive consumer itch.

I talk to people all the time about monies set aside for something they call emergencies, but they aren’t my grandpa’s emergencies. Today, emergency funds find their way to sales racks, vacation rentals, down payments and holiday gifts. None of these things are emergencies.

An emergency is an unexpected, involuntary moment which threatens to get worse if not resolved. I’m talking about a job loss, major medical bills, insurance deductibles, veterinarian bills and various other expenses which are your worst nightmares.

Misidentifying an emergency often leads to an emergency. One of the more common mistakes I see is using an emergency fund as a down payment on a home. What’s one of the most emergency-inducing lifestyles you can live? Homeowner. If you vanquish your emergency funds in the process of becoming a homeowner, then you’re just asking for trouble — and debt.

You can decide to not go on vacation. You can decide to not buy a new TV. And you can decide not to spend too much on holiday gifts. You cannot decide the timing of a true financial emergency.

An emergency fund, one with absolutely no risk attached to it, should consist of at least three months worth of household expenses. If you want a larger emergency fund, fine.

But somewhere along the way, that emergency fund will start to feel like bulk unassigned savings, and you will want to dip into it. I prefer you put three months worth of expenses in an account, and put nothing else in it. Maintain a second account for down payments, vacations and whatever else isn’t an emergency. If you want to put that at risk, have at it. Although putting money you know you’re going to spend soon at risk doesn’t make a tremendous amount of sense, either.

Does it stink to have $10,000 or more earning a very small amount of interest? Yes. Does it stink as bad as turning on your “emergency only” flashlight only to find out the batteries are dead from nonemergency use? Nope.

I know a guy who keeps $15,000 cash and a bunch of gold coins in his home safe. I’ve always been fascinated by this move. But frankly, it’s not terribly different than keeping an emergency fund in a savings account. He’s not trying to risk it, and it’s actually more readily accessible than keeping that money in a bank.

Don’t risk your emergency fund, and don’t commingle it with nonemergency money. When an emergency shows its ugly head, you won’t want to have to take yet another loss.