Setting up an emergency fund is one of the smartest decisions you can make with your money. These savings help you handle unexpected expenses that crop up from time to time.
With this in mind, you might believe there’s no such thing as being too prepared for the unknown. But having too much money sitting in your emergency fund may be a poor use of your cash.
Most People Have the Opposite Problem
According to conventional wisdom, savers should have three to six months of living expenses in their emergency fund. With a goal this high, an emergency fund is a pipedream for most people. Some 18%of Americans and 13% of Canadians don’t have enough savings to cover an unexpected $500.
Without $500 in your emergency fund, you might have to borrow an online personal loan or line of credit. Plenty of people rely on online borrowing options when their savings fall flat, as these convenient online loans provide a safety net in emergencies.
If the alternative is using a line of credit, having too much money in your emergency fund might not seem so bad in comparison. That’s a problem you would rather have. After all, you’ll have a huge cushion to fall back on any time you need to pay an unexpected expense, take unpaid leave, or you lose your job.
However, exceeding the six-month goal could be an impractical use of your wealth. If you have that much money, there are better ways to invest it.
Why Can You Save Too Much?
Eventually, super savers will pay off a line of credit and sock away serious cash into an emergency fund. If they’re lucky, they won’t run into an emergency for years and years, during which time their savings will slowly amass.
If you’re in the same boat, you should keep an eye on your account balance. Overstuffing your emergency fund comes with two drawbacks:
1. Your Money Loses Value
Most basic savings accounts offer paltry interest rates on deposits, so your money here won’t grow over time.
Usually, this isn’t a problem for people with less than six months of expenses saved. A low interest rate doesn’t matter, since your emergency fund is meant to be used. You’ll withdraw this cash before it can lose value to inflation over decades.
But the more money you save, the longer your savings will sit in an account. During that time, it may be only earning 1.5% to 2.5%, far below today’s inflation rate.
2. You Lose Out on Other Advantages
Tax advantages are another thing absent from basic savings accounts. That means you have to pay tax on the interest you earn on your emergency fund. But more importantly, putting all your savings into an emergency fund means you might not be saving as much as you should be in a tax-advantaged retirement plan, like an RRSP.
Not only do you not have to pay taxes on your contributions, but you also earn more interest in these investments.
How Should You Spread Out Your Savings?
A higher interest rate and tax advantages are important features that help you grow long-term wealth, but they aren’t reason enough to transfer emergency savings into these accounts. These high-yield, tax-advantaged accounts often come with maturity terms, withdrawal holds, and balance minimums that make them inappropriate places to put your emergency fund.
You still need a basic account for ease of access — just don’t overstuff it. Transfer the excess to prepare for long-term goals beyond the next unexpected expense.