One of the hottest debates in personal finance is whether or not to invest your emergency fund. Pros and cons exist on both sides, but the right answer is no, you shouldn’t invest your emergency fund.
The only exception to that rule is if you have an extremely high risk tolerance.
Here’s why you should never invest your emergency fund.
Why You Shouldn’t Invest Your Emergency Fund
Understanding your emergency fund’s purpose (also called an e-fund or rainy day fund) is important. Your e-fund isn’t there to help you build wealth. Its purpose is to keep you out of debt when unexpected expenses happen.
For instance, if your roof springs a leak, having $20,000 set aside in a HYSA (High-Yield Savings Account) like Ally makes this expense no big deal. Pay by credit card, log into your savings account where your emergency fund is stored, and pay off your credit card.
Then, set up an automatic transfer from your primary checking account (where your paychecks get deposited) to your savings account to help rebuild your emergency fund back to where it was before your leaky roof.
What you never want to do is be forced to sell investments to pay for an unexpected expense.
Why? Because selling investments triggers capital gains taxes. It also takes longer than making a quick and easy transfer from your savings account.
You always want to be in control of when you sell stock, not an emergency expense.
The Pros and Cons of Investing Your Emergency Fund
Though I firmly believe you should never invest your emergency fund, I would be remiss if I didn’t discuss the pros and cons of doing so. There are pros to investing your e-fund, but there are more cons.
Pros of Investing Your E-Fund
- Higher Potential Returns: Investing your emergency fund can earn a higher return rate than keeping it in a low-yield savings account. This can help your money grow over time.
- Inflation Protection: Investing can provide a hedge against inflation, eroding your money’s purchasing power if it’s left in a low-interest savings account.
- Diversification: Depending on your investment choices, you can benefit from diversification, spreading your risk across different assets or asset classes, potentially reducing overall risk.
Cons of Investing Your E-Fund
- Risk of Loss: All investments come with a degree of risk, and there’s no guarantee of positive returns. You could incur losses if you invest your emergency fund and the market experiences a downturn when you need the money.
- Liquidity Concerns: Emergency funds are meant to be readily accessible in times of crisis. When you invest, your money may not be as liquid, and you might have to sell investments, which can take time and potentially result in capital losses.
- Volatility: Investments can be subject to market fluctuations, and the value of your emergency fund might be significantly lower when you need it most. This can create added stress during emergencies.
- Taxes and Fees: Depending on your investment choices, you may be subject to capital gains taxes or other fees that can reduce the overall investment return.
- Short-Term Goals: Emergency funds are for short-term financial needs; the primary objective is safety and accessibility. Investing is more suitable for long-term financial goals where you can ride out market fluctuations.
- Discipline: Investing your emergency fund requires discipline and the ability to separate it from your regular investment portfolio. You should have a clear plan for accessing the funds only in case of genuine emergencies.
- Market Timing: Timing the market can be difficult, and you might need to access your emergency fund when market conditions are unfavorable for selling investments.
In conclusion, don’t invest your emergency fund unless your risk tolerance is high. And if you don’t have an emergency fund, start building one today.