Should you invest your emergency fund? With enough extra money, yeah
If I had to choose one financial movement that has had the most impact on my life, it would probably be the constitution of an emergency fund.
Having a cushion of cash reserves to cover unforeseen expenses gave me peace of mind not only when I had to fork out cash for a new transmission in my car or to drive through a low income months, but even when I do not actively need the money. Knowing he’s there if I do keeps a lot of my anxieties at bay.
However, I still have this nagging feeling that I am wasting this money letting it sit in a savings account. Although I earn hundreds of dollars in interest each year using a high yield savings account, my income usually does not exceed inflation. This means that in terms of purchasing power, I am losing money.
Then a leading money scholar and financial writer revealed a secret to making that money work for me: I could invest my emergency fund – or at least part of it. Miranda Marquit has written about this strategy several times and his advice caught my eye. It was both scary and intriguing, so I decided to ask her what she thought I should do.
Should I invest my emergency fund?
A key factor in my situation is that I have saved more money than I need for my emergency fund: most guidelines recommend six months of basic living expenses, and I have the value of a whole year. While my job as a freelance is less stable than a full time job, I have no children, I have no property and I work remotely, so it would be easy for me to live on very little if I needed it.
Because I saved a good amount of money, Marquit told me that it made sense to invest some of it. “That big amount of money in a savings account isn’t doing as much as it could be,” she explained.
And she is right.
I keep $ 30,000 in a high yield savings account (plus a $ 5,000 cushion in a credit union savings account linked to my checking account). I earn an APY of 1.80% on that $ 30,000, which is one of highest interest rates on a savings account available now. In one year, I would earn $ 540 in interest on that money.
That probably sounds like a lot to people with savings accounts at national banks, where you typically earn pennies – maybe a few dollars – in interest each year. However, that’s not so much when you consider that the inflation rate in 2019 hovered around 2% and the historical average stock return is 10%.
Investing your emergency fund puts your savings at risk
Of course, investing my money does not mean that I will get a 10% return. This is a long term average, and is great for estimating the returns on your Pension saving but not on investments that I might need to withdraw in a year or even a few months.
Once I invest this money, I could lose it. In a savings account, my money is guaranteed, insured by the FDIC. And because I never know when a financial emergency is going to strike, it’s impossible to wait to sell my investments at a profit.
“You might have to sell your investments at a loss,” Marquit told me. “However, if you have the stomach for it, it is possible to see a silver lining.” That silver lining is a potential tax deduction.
This is what happened to her when she had to sell a small number of shares when groundwater entered her basement and caused costly damage. “I had to sell at a loss, but then I was able to deduct that loss from my taxes,” she said. “So I had access to the capital I needed, it didn’t wipe out my account, so there was money left over and my emergency became tax deductible.”
To do this, you must accept that you could end up selling your investments at a loss. This was the main point that Marquit drove home, and as someone who has never been afraid of a little risk when there is potential for reward, I decided that to invest a part of the extra money in my savings – about a third – was the right decision for me.
I plan to invest short-term savings differently from long-term savings
Marquit explained that she takes a tiered approach to her emergency savings.
“I keep about three to four weeks of spending in a high yield savings account. The rest is in a taxable investment account,” she said. That way, she can immediately use the money in her savings account, and if she needs more, those funds will cover her while she liquidates her investments.
I was most worried about the risk. I knew I wanted to have easy and quick access to at least part of my emergency fund, and I didn’t want to invest the rest in something too risky or complicated.
I also knew that I needed my investments to be liquid enough, in other words, that I could sell them quickly and not incur penalties, like early withdrawal penalties for cashing out a retirement account at an early age.
Marquit said she was allocating her emergency fund differently from a long-term investment. While his retirement account is 90% stocks and 10% bonds, his emergency fund is split 50/50 between stocks and bonds. In theory, this would alleviate much of the volatility that investment accounts can experience.
Only time will tell if investing some of my savings was the right decision, but I feel good.