We just had this same dilemma in my own household. After having tapped our emergency fund for immediate cash to use a down payment on our new house, we’ve now got a big hole to fill.
But that poses a financial problem. Every penny we earn that exceeds our budget is supposed to go towards our early retirement by age 45 plan.
Plus, as we’ve demonstrated before here, saving your money in tax-sheltered accounts can compound into huge financial benefits later on.
So then, why am I choosing to build back up my rainy day fund and put my extra retirement savings efforts on pause for a moment?
For a very good reason! But first, let’s weigh out the two choices to better understand how one may be more advantageous than the other.
Saving More for Retirement
Just to be clear, it’s not like I’m not saving “nothing” for retirement anymore. We’re still saving a boat-load of money in our Roth IRA’s and 403(b). I’m also saving way more than I need to in my new 401(k) in order to meet the full employer match at my new job.
My attitude towards trying to achieve financial freedom has always been to save all the way up to the IRS limit for each our tax-sheltered retirement accounts. That’s exactly how Robert and Robin Charlton from the book How to Retire Early were able to pull off retirement by their early 40’s.
Also by maxing out the IRS limits, you not only build up a tremendous amount of capital very quickly, you also save yourself thousands of dollars in tax payments every year.
Think about it: Who would you rather pay – yourself or the tax man?
That’s what I thought!
Rainy Day Savings Don’t Really Generate Money
One of the biggest criticisms I’ve always heard from people AGAINST having too much in rainy day savings account is that they don’t make you any money.
Why in the word would I want to park +$10,000 in a savings account that earns less than 1% interest?
What does that work out to in earnings? … $100 in interest for the year? (Sarcastic) Oh, Boy!
Invest that money into a stock market index fund and you could be potentially earning an average of 8 to 10% interest annually.
While one year might not be a big deal, what about 3 to 10 years? You could be missing out on a lot of potential earnings!
Even on this site here I posed the same sort of question when I was trying to decide if I should invest a portion of my emergency savings in a semi-stable mutual fund. My logic – why not invest a small portion in a fund that is made of semi-stable assets like bonds and money market funds. (By the way – I lost about $100 on that decision when I finally cashed it out. I guess that wimpy 1% savings account was the better choice after all!)
So while you may not be exactly killing it in earnings by keeping a sizeable rainy day savings fund, does that really make it the better decision … financially?
How about we look at the bigger picture and look at things from a different angle.
Avoiding Credit Card Debt
What happens when trouble arrives?
Unfortunately for a lot of people, the first place they look to for relief is a credit card. Why? Because it’s a very quick and easy solution to get cash in a flash.
Oh, no! Your car broke down? You’re not going to have time to go get a few extra thousand dollars to get it fixed. You’re going to NEED a solution fast! That’s where you get into the credit card trap. You just swipe that card and the car shop goes to work making everything better.
But then after a month, the trouble begins. You’re stuck trying to figure out how you’re going to come up with enough money to cover this mess. And unfortunately if you don’t have enough to pay for it all at once, then you’ll be looking at being charged anywhere from 15 to 30% interest ON TOP of the balance you weren’t able to afford.
Hello and welcome to DEBT city!
So, if we think about it in that way, there is an opportunity cost involved by not having a rainy day fund ready to go. Your emergency fund is potentially saving you 15 to 30% in future interest penalties; interest you would have to otherwise pay off if you weren’t ready for it.
So in a sense, 15 to 30% is actually what your emergency cash is really worth to you!
While there may not be direct earnings to be made on a rainy day savings account, there is certainly an opportunity cost … and it can cost you BIG if you’re not prepared. That’s why I’m going to focus to building back up our emergency fund before I worry about trying to save above and beyond for retirement. Once things get back up to a sustainable level, then we can start applying the extra earnings towards my extreme saving goal. But until then, building up those emergency savings for anything that might or might not happen will be what we focus on. Even though the savings may not be earning me 10%, stock-market-style returns, the fact that it could potentially rescue me from 15 to 30% credit card debt is enough to capture my vote.
Readers – What motivates you to build up your emergency fund; despite knowing that you won’t be making millions of dollars in earnings from it?