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Is an Emergency Fund Overrated? Many financial advisors preach that establishing an emergency fund equal to 3 – 6 months worth of living expenses is an essential part of a sound financial plan. I've remarked on this subject in posts before, but maybe a little analysis is in order. Are they right? (Not in their political leanings, in the quality of their financial advise).

If you are just graduating from college, chances are you have many things on your plate. Obviously everybody's situation is a bit different, financial and otherwise. If you're just Joe/sephene average however, I'll assume you make an average salary for a recent college graduate. For 2005 a business graduate with a bachelor's degree the approximate average was $42,964, if you majored in computer science - $49,585, nursing $61,276, communications $31,517, engineering $51,053, and education $29,332. All salary figures drawn from the 2006 Job Outlook report. It sure pays to be a nurse.

The average of these figures is $45,337, so I'll use that figure for analysis purposes. If you were making the average graduate salary of $45,337, should you start an emergency fund equal to 6 months worth of living expenses? I say no, and here's why. In the first place, you are betting a fairly large sum of money that you'll have an emergency. By doing so you are probably failing to fund your 401K or other retirement vehicle to the fullest extent you could. That means, in the case of a 401K, there's a good chance you're leaving your employer's matching funds on the table. Bad idea. That's free money, and you know how hard it is to come up with that.

By funding your retirements and other investments early, you are taking maximum advantage of compounding, the financial principle that will make your retirement fun and enjoyable, much less possible before you're 80. Many of you have probably seen the figures that if you save money for 10 years and then stop saving, you'll be forever ahead of someone else that begins saving when you stop, then contributes money for 20 years. That's the power of compounding. Here's a review, which ignores the benefits provided by an employer match.

If you assume 8% interest compounded daily, and a $500 monthly contribution, after the initial 10 year period, you'll have $91,921. After 20 more years of no contribution, that grows to $455,208. If you had a really good time and spent your $500 a month for the first 10 years instead of making your investment contribution, here's how you'd end up.

After 10 years, you'd obviously have nothing but memories. After 20 years of saving, you'd have only $296,477. If you went 10 more years, but upped your monthly contribution to $1,000, you'd end up with $843,606 in your retirement account, 40 years after you left college. If you were trying to catch your friend that started putting away the $500 per month right after college by doubling your monthly contribution, it would be in vain, however. If you just did the 10 year contribution plan at $500 per month, you'd have $1,012,994.97 at the end of the 40 year period.

That's one reason that I'd say that if building up your emergency fund means cannibalizing your retirement account, you're just ensuring an emergency in retirement by preparing for an imminent emergency now. If your emergency fund was earning the current money market account average interest of 3.66%, you'd take over 3 years to establish an emergency fund with $20,000 for 6 months of living expenses. If you kept that in a money market account for liquidity, but made no more contributions, you'd end up with about $79,000 at the end of 40 years, assuming the same 3.66% interest rate. How much does that cost you? Sit down.

You now have only 36-3/4 years to save before your 40 year retirement begins. If you still saved for the 10 years at 8%, then sat on it for 26-3/4, you'll be left with $781,093, plus the $79,000 in your emergency fund, for a total of $880,093. That's a $132,000 loss from where you'd have been without the emergency fund diversion. There's your emergency, Bucko. My personal feeling, and you may or may not agree, is to ditch the emergency fund, or at least have a much smaller one, say $2,500 - $3,000, and fully fund your retirement accounts. That would keep you from having to dip into credit cards for things such as car repairs, If you truly have an emergency, you can find an alternative source of funding. If it means you end up with some high interest debt, that would be regrettable, but chances are that won't be the case.

That doesn't even touch on the possibility that the establishment of an emergency fund could keep you from buying a house until some years down the road. In most cases, owning a home will add to your retirement assets, instead of enriching a landlord somewhere (you should become one of those, eh?). This is all just my personal opinion, and I'm not a financial adviser, but I definitely have at least $.02.

Have a great week end.