Building an Emergency Fund is one of the first steps to improving your finances, right up there with reducing debt. Emergency Funds are an amount of money, typically 3-6 months worth of expenses, set aside to be specifically available in the event of an emergency – hence the name. An emergency fund should be kept in accessible and safe holdings such as money market funds or High Interest Savings Accounts (HISA). Advantages of an Emergency Fund are lower stress and encouraged saving. Some emergencies the fund prepares for are:
- Job Loss
- Car troubles
- Home repairs
- Necessity replacements like a phone or computer if they break
Why do I need an emergency fund?
“I have a lot of savings in investments that I could just sell if there is an emergency, why should I have that much money just sitting around?” This is a valid question to ask. You could just put all your money into investments and ignore the emergency fund, as long as things are going well, you’ll be making much better use of your money that way. This is much higher risk though, because if there is an emergency, you could be forced to sell your investments at a bad time, doubling down on the loss of the emergency. Emergencies often happen in groups. Job loss for example could very easily happen alongside a recession. If this happens, you really don’t want to be forced to sell your investments at a low.
Recessions are not good for the majority of the population, but certain groups are hit harder than others. The hardest hit group are those wealthy enough to have investment accounts, but not wealthy enough (or haven’t planned well enough) to have the cash available to withstand a recession. If the income of a person in this group is seriously affected by the recession (by job loss or loss of sales if they own a business), they will be forced to sell their investments at a low during the recession. This can cost you big money and is the reason why investing your emergency fund is a risky choice. COVID-19 is the perfect example for how bad not having an emergency fund could punish you. If you were laid off at the start of COVID-19, were cash poor, and had to resort to selling off your investments to survive – you could have easily been forced to sell at a 30% or more loss (80%+ if you held oil companies or other hard hit sectors) than what they were worth just a month before. On the flip side, if you did have an emergency fund, indexes like the S&P500 came back to being within 10% of what they were within a couple months of the original dip. In this particular scenario, a lot of the layoffs were shorter term as well as the lockdown loosened. For those people, they might have made it all the way through without having to sell any of their investments off if they had a proper emergency fund. However, even if they are still laid off and eventually did have to start selling – they are getting an extra 20% out of their money by not being forced to sell at the worst point.
Improving the efficiency of your fund
We have talked about the low risk version of an emergency where you have the full 3-6 months in safe, accessible accounts. We have also mentioned the high risk-high reward option of barely holding any emergency fund and instead investing the money. Fortunately, there are ways to set up an emergency fund that allow you to avoid sitting on too much cash while also not being extremely risky. These methods should only be used by those very comfortable with their finances.
Using your mortgage: A lot of mortgages have special options for extra payments. One common method is the double-up payment. This typically allows you to make an extra payment on the principal of the mortgage early while also giving you the option to skip-a-payment later on. This can be used as part of your emergency fund. Parking your money in the double-up payment is essentially giving you the same returns as your mortgage rate. So if you have a mortgage rate of 3%, that is essentially the returns you are getting on that money and those returns are guaranteed. If an emergency arises, you can now use the skip-a-payment to save money. Having $1,000 in savings for a mortgage payment is the exact same as being able to eliminate that expense instead in an emergency. While you shouldn’t put your entire emergency fund into this, putting in a couple months worth of mortgage payments could improve the efficiency of your emergency fund. It is still a little more risky because in an emergency where you require a large sum of cash up front (say your car died and you need to buy a new one ASAP), you will not have that cash immediately available. This can be offset by the addition of the next method for improving the efficiency of your emergency fund:
Line of Credits. Of course a secured line of credit such as a Home Equity Line of Credit (HELOC) is better, but a standard line of credit works as well. These give you access to fairly low interest debt you could use in the event of an emergency that requires up-front cash. At the time of writing this, you can get HELOC’s with rates lower than 2.95%. This means you can use low-interest debt to avoid being forced to sell off investments at a low even if you don’t have a ton of cash available. In the recession example above, if you used a line of credit instead of selling at the low, the line of credit would have cost very little. When the market returned from the dip, you could sell off your investments to pay off the line of credit. The results would be a small interest fee but avoiding taking a heavy hit on selling investments at a loss. If you are using the previously mentioned double-up payment to bolster your emergency fund, you can use a Line of Credit for access to quick cash and then use the money you are saving by skipping mortgage payments to pay off the line of credit over a couple months instead.
I have 3 months worth of double up mortgage payments saved up. Each monthly payment is $1,000. I also have an emergency fund of $3,000 and a Line of Credit available for $3,000. I am hit with an emergency that will cost me $6,000 up-front. So I use my emergency fund of $3,000 and Line of credit for $3,000. To pay off the line of credit, I now utilize my skip-a-payment over the next 3 months. This saves me $3,000 that would normally be spent on mortgage payments that I now use to pay off the line of credit.
What is the benefit of this? Home equity line of Credits in particular and mortgages dont have extremely different rates. So if you used the double-up payment and the money sat there for a couple years before you had an emergency, the amount of interest you avoided paying on your mortgage would be quite a bit more than whatever you paid for interest on the line of credit.
There are lots of options for building and diversifying an emergency fund while still trying to maximize efficiency. How you build yours depends on your tolerance for risk and your need to maximize efficiency. Some people hate risk and others aren’t worried about the relatively minor returns of maximizing efficiency. Those types of people would just prefer to have an all cash emergency fund. Others take the risky road and put it all in investments. Most take a path somewhere down the middle. The most important thing is that you have a plan and you stick to it.