Let’s talk about emergency money … or …
The «Oops» account.
A «Rainy Day» fund.
The «$ ht Hit the Fan» account.
However you refer to it, an emergency fund is vital to the long-term financial well-being of everyone. In a pinch, an emergency fund is a safety net that can help you avoid unnecessary debt, weather a financial crisis, and get back on your feet after countless unexpected bends in your way.
What is an emergency fund?
An emergency fund is simply cash that you have set aside to cover unexpected expenses. When you think about your money, you have your «normal» income and expenses. This can include your rent or mortgage, utilities, car payment, insurance, groceries, and more.
But what if your car needs a new transmission? Or does a pipe burst in your house? Or are you suddenly unemployed?
This is where an emergency fund comes into play. It’s cash that you have available to pay for these expenses so you don’t get into debt (or more debt), or worse, you just can’t pay and have more problems to deal with.
How Much Do You Really Need?
For many, the answer to this question can be found in the recommendations of people who are considered financial experts. Contrary to your opinion, a quick overview of this expert financial advice may not offer a specific solution. In fact, abandoning your search for adequate funding for an «EF» can become very confusing. When faced with multiple options, it is sometimes difficult to make a final decision.
«Save six months on expenses»
«Save a year on expenses based on your budget»
«Save $ 1,000 On An EF Baby»
These options are examples of expert advice shared daily. With all the options available, how do you decide which method to follow?
The key to successfully navigating the waters is remembering that setting up, funding, and using an EF is a personal decision. Regardless of what an expert suggests as the best way to set up an emergency fund, you’ll need to tailor your approach to suit your personal situation. Notice, personal finances are personal.
Whether you are saving a month, six months, or twelve months in expenses, the point is that you are saving some. This is especially true if you’re just starting out on your own:
Save something; something.
How to build it
As you start building your emergency fund by saving all you can, here are some tips to keep in mind:
- Deposit the account regularly. One of the most important components of an emergency fund is the actual funding of the account. It has to be automatic, like something you do every week, month, or year. Now, if you are struggling to pay your bills or meet your obligations, think about the benefits of having a bit of air to breathe. In this case, even if it’s only $ 25 a month, something is always better than nothing. Look for the best checking accounts online to get one with great rates and fees.
- Overestimate what you think is necessary. One caveat with EF funding is that people often miscalculate how much they are going to need. If you want to base your balance on a certain amount of monthly expenses, consider adding a buffer to manage the inevitable visits you receive from Murphy.
- Use separate accounts. An emergency fund should not be held in the same daily checking account that you use on a daily basis. It should also not be confused with long-term goal savings like a home down payment fund or future tuition fund for your children.
- Customize your approach to suit your specific situation. Once you’ve found a plan that sounds best to you, don’t forget to make sure it is right for your specific needs. Base your projections on factors such as the number of streams of income you / your family have, medical needs, child care costs, etc.
- Remember, EFs are liquid. Above all, keep in mind that the balance of your emergency fund may always change, similar to your living circumstances. You may need to spend some of the funds, but you should also work on replacing those funds once you have recovered from the setbacks or challenges that involved using the money. By treating your EF as a fluid unit, you are one step closer to maintaining financial freedom.
Where do you put it?
Once you’ve created it, you should keep your emergency fund in a high yield savings or money market account to work for you. You could also consider looking at CD accounts, but that will tie up your money a bit.
Why these types of accounts and not just your checking account (or money under a mattress)?
Because when you have money just waiting to be used, you want to earn interest on it. If you have money in a savings or money market account, you will receive residual income through interest. It might not be a lot of money, but it is free money to do nothing with your emergency money!
Alternatives (use at your own risk)
Let’s talk about some alternatives to accessing cash in an emergency. While a savings account is king (because cash is king), there are other options that need to be considered. However, these have advantages and disadvantages and should only be used by certain people.
When you think of an emergency fund, you want to:
- It must be cash or cash equivalent (i.e. no gold, artwork, etc.)
- It must be relatively liquid (i.e. you will need the money in 3 days or less)
- It has to be safe – in many cases when the stock market or economy is in turmoil, and if you don’t have «safe» assets, what you thought $ 100 is actually $ 50 is what you need cash
- You should be able to add or reduce the account with relative ease as needed
Credit cards are one of the most popular alternatives to an emergency fund, especially for people who are out of debt. You pay them out in full every month and use them for points. When you have a great reward credit card, you can get sizable cash back using it as an emergency fund.
Some credit cards, like American Express Platinum, don’t have a pre-set spending limit for qualified individuals, so you can spend what you need.
The big drawbacks are the high level of interest in a credit, as well as the very low risk of your card being closed when you need it most. In the early days of the Covid-19 emergency, Chase and American Express are closing thousands of accounts, reducing balances to even more accounts. They did this to reduce their own risk. If you are a user you might get in trouble when you need to use your card.
Benefits: Easy access, can be used to pay virtually anywhere.
Disadvantage: High interest, potential for closure.
Home Equity (HELOC)
If you own a home, developing your equity is viewed by many as a potential emergency fund. This is especially true if the emergency involves a home repair.
While using your home as an emergency fund sounds tempting – low prices, you can use a debit card, and a lot more – it comes with risks too.
The first risk is simply that you will pay interest on it. If you don’t pay, you can lose your home. But with mortgage interest rates at near all-time lows, this is pretty minimal.
In my opinion, the greater risk is that in a real financial crisis where you may need to access the money, your bank could freeze your HELOC and prevent you from using it. Banks are allowed to do this to limit their risk. If they think your home value has gone down, you simply cannot spend your HELOC anymore. This happened in the last real estate crisis, 2008-2010.
Benefits: Large amount available, low interest rates for HELOCs
Disadvantage: Tied to your home, can be frozen.
Portfolio line of credit
If you have a large portfolio in a taxable account, you can tap into that money with a portfolio line of credit. So many investors are accessing their money without having to sell investments.
Instead of selling your stocks and paying capital gains taxes, savvy investors simply use a portfolio line of credit to get a loan at a low interest rate. Many brokerage firms allow you to borrow between 35% and 50% of the value of your portfolio at low interest rates of 3.5% to 8%.
This is an attractive alternative if you have a large portfolio. The risk is that if your portfolio value declines, you could be subject to a margin call – where the broker demands that you repay some (or all) of your loan, or that they sell your assets to repay the loan. In a financial crisis, when stocks are falling, this could be a bad situation.
Benefits: Inexpensive access to capital, avoidance of capital gains taxes
Disadvantage: Subject to a margin call in the event of falling asset prices
An emergency fund is especially important when embarking on your personal financial journey. Even if you have a little wealth, it is a useful tool for managing the inevitable «unexpected» expenses that you will encounter.
If you have a significant portfolio it might be worth trying an alternative to cash in a savings account, but at the end of the day «cash is king» and while you might have cash «not productive», peace of mind is usually more worth than any marginal return you could get.
What is your measure of how much you hold in your emergency fund?