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I've seen several financial advice websites and books that recommend keeping some amount of money (usually a function of your monthly expenses) in cash as an emergency fund. See for example questions here, here, and here

My question centers around the possibility of using an unsecured line of credit for a liquid emergency fund. It seems to me this has essentially the same pros and cons as storing funds in a savings account, with the extra tricks being that:

  • Any cash you would otherwise have kept sitting in a low interest account can now be invested somewhere better.

  • Actually using the funds now entails paying a modest interest rate

It seems to me that if an emergency fund's purpose is to hold you over in the event of an emergency, then the extra interest one pays is a minor concern. Obviously you might wish to keep some of the fund in actual hard currency in case of a real "ATMs are down" emergency, but for the remainder, why would one not just rely on the line of credit?

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    Think of an emergency fund as an insurance policy not an investment. There is a cost to having car insurance, as there is a cost to an emergency fund. Also borrowing money to cover an emergency, could turn it into a disaster. – Pete B. May 5 '15 at 14:58
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    Suppose there is an unexpected emergency so dire that you immediately need many thousands of dollars. Now, I will offer you the following choice: (a) deal with the emergency, or (b) deal with the emergency and also suddenly and massively increase your debt. Which option sounds better? – Eric Lippert May 6 '15 at 5:51
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    The problem with borrowing money is that usually to get a loan you have to prove you don't need it. – CaptainCodeman May 6 '15 at 9:47
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    There's certain things you can't pay with a line of credit... like a mortgage. If you lose your job (which I'm sure qualifies as an emergency to a lot of people) you would need some savings in reserve to continue paying your mortgage. – Robert Penridge May 7 '15 at 15:27
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People treat an emergency fund as some kind of ace-in-the-hole when it comes to financial difficulty, but it is only one of many sources of money that you can utilize.

What is an emergency?

First, you have to define what an emergency is. Is it a lost job? Is it an unplanned event (pregnancy, perhaps)? Is it a medical emergency? Is it the death of you or your spouse?

Also, what does it mean to be unplanned? Is being so unhappy with your job that you give a 2-week notice an emergency? Is one month of planning an emergency? Two?

Only you can answer these questions for yourself, but they significantly shape your financial strategy. Planning is highly dependent on your cashflow, and, for some people, it may take them a year to build enough savings to enable them to take 3 months off work. For others, they may be able to change their spending to build up enough for 3 months in 1 month.

Also, you have to consider the length of the emergency. Job-loss is rarely permanent, but it's rarely short as well. The current average is 30.7 weeks: that's 7 months!

Money in an Emergency

There are six main places that people get money during a financial emergency:

  1. Savings accounts (included in this is CDs or other guaranteed financial instruments)
  2. Investment accounts (stocks, bonds, etc.)
  3. Secured debt (Equity loan)
  4. Unsecured debt (credit cards, LoC)
  5. Insurance
  6. Supplemental income (Social security, unemployment, side job)

A good emergency strategy takes all six of these into account. Some emergencies may lean more on one source than the other. However, some of these are correlated.

For example, in 2008, three things happened: the stock market crashed, unsecured debt dried up, and people faced financial emergency (lost jobs, cut wages). If you were dependent on a stock portfolio and/or a line of credit, you'd be up a creek, because the value of your investments suddenly decreased, and you can't really tap your now significantly limited line of credit.

However, if you had a one or more of cash savings, unemployment income, and unemployment insurance, you would probably have been OK.

Budgeting for an emergency

When you say "financial emergency", most people think job loss. However, the most common cause of bankruptcy in the US is medical debt. Depending on your insurance situation, this could be a serious risk, or it may not be.

People say you should have 3x-6x of your monthly income in savings because it's an easy, back-of-the-envelope way to handle most financial emergency risk, but it's not necessarily the most prudent strategy for you.

To properly budget for an emergency, you need to fully take into account what emergencies you are likely to face, and what sources of financing you would have access to given the likely factors that led to that emergency.

Generally, having a savings account with some amount of liquid cash is an important part of a risk-mitigation strategy. But it's not a panacea for every kind of emergency.

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    This is a well thought out answer that's challenged me to think about my own emergency money. – James Khoury May 5 '15 at 8:22
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    I've accepted this as it is the most complete and nuanced answer. Shawaron's answer also makes a good point about emergencies that could reduce the availability of a LoC, but, as outlined in Nick2253's answer, this is only one possible scenario. – John Doucette May 5 '15 at 16:56
  • If you were dependent on a stock portfolio A way to account for this is to double or triple your emergency fund invested value, ie if you need $10k for your e-fund, make your stock value of it sit about $30k, so you can withdraw the needed $10k even if the market is down 60% – enderland May 5 '15 at 17:22
  • @enderland: What you are saying is basically, if you have more assets to begin with, then even if you lose some, you will not go bankrupt. But this is trivial and not limited to stock portfolio in any way. In any case, stock portfolio might make for a good investment because of (possibly) good returns, but because it is unpredictable, it is an awful way to store emergency funds (unless you carefully hedge your investments to protect against particular crises that might befall you, but I don't think it is easy to do that properly). – tomasz May 5 '15 at 17:35
  • @enderland I wouldn't make that my first line of defense. A loss of 60% is rarely permanent, and the markets generally rebound over time. But if you are forced to withdraw at such a wildly inopportune time, you'd see yourself basically kneecapping your future investments. With at least non-trivial cash or credit access, you wouldn't have to liquidate stocks for most small emergencies. – Nick2253 May 6 '15 at 14:18
59

An emergency fund is your money, sitting in a bank, that you can use for emergency purposes.

A line of credit is somebody else's money, that they've provisionally promised to let you borrow. But they can change their mind at any time.

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    In the last housing crisis many people found their lines of credit reduced or closed without warning. Too bad if they needed it. – mhoran_psprep May 4 '15 at 21:17
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    @mhoran_psprep Or if they were actually using it. "We're reducing your unsecured credit line by $5,000. Please give us our money within two weeks of the date of this letter." is not something you want to receive if you have no emergency fund and just lost your job. – a CVn May 5 '15 at 7:33
  • Both are useless if the banking system collapses. – mckenzm May 7 '15 at 2:23
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    @mckenzm: Well, money is useless if the dollar collapses. – Mehrdad May 7 '15 at 3:22
  • As if dollar would be the only strong currency in the world. Even at this time, Euro could be key currency too. Of course, things would change, but it's not as money would be useless. – Sempie May 7 '15 at 13:22
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Stop trying to make money with your emergency fund. It's purpose is to sit there idly waiting for a bad day. A day when you need that cash (liquid) not in a bank or a line-of-credit.

The few dollars you might make trying to chase interest/investments with your emergency fund aren't worth it if a true emergency came up and you couldn't get to your cash in time.

Once you have a fully funded EF then start investing heavily. That's your future game plan. Not the EF.

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    While I agree that this is good advice in the vast majority of cases, it seems to be a poor answer to the specific question being asked which is about advantages of the possibility of using credit, rather than whether one should be trying to make money from one's emergency fund. – a CVn May 5 '15 at 7:36
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recommend keeping some amount of money in cash as an emergency fund

I see two keywords, with two interpretations here.

Cash:

  1. Money on demand deposit, not tied up in term investments or anything that requires a buyer in order to liquidate.
  2. Small pieces of paper, usually with a portrait of the current/notable head of state on it, that other people will accept in exchange for goods and services.

Emergency:

  1. Personal emergencies where you need money immediately. No one else is affected.
  2. More widespread emergencies where many of the things we take for granted (like the financial system) are not available for an extended period. Large blackouts, floods, earthquakes, stock market crash etc.

1 + 1 is rarely a problem. Even if it takes a couple of days to sell reliable investments.

1 + 2 is a rather large problem. You need to leave town, today, because the town won't be there tomorrow. You're out of gas, and the phones are not working. The guy minding the local service station with an AR-15 can't process your Amex Centurion card and would prefer actual cash.

I live in an area prone to earthquakes and cyclonic storms. The last large one didn't knock out anything major, but the cash machines emptied out rather quickly. We keep a month's income in cash in the house, and I have a spare tank of gas in storage*.

As others have said, there is no single answer for everyone. But do consider what you take for granted and what happens when it goes away.

*Change it every 2 months - common gasoline is not chemically stable

8

Why can't you have both?

If you do have both credit and an emergency fund, and an emergency occurs, you can draw from the line of credit first. Having debt + cash is a much more stable situation than having neither, because then you have the option to use the cash to pay off the debt, or use the cash to pay other expenses. If you just have cash, when you spend it it's gone and there's no guarantee anyone is going to lend you any money at that point.

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    Why not both? In general, illiquid investments have a higher return than liquid ones. If a line of credit were adequate, then the emergency-fund money could be put into a high-return investment rather than a low-return one. – Mark May 5 '15 at 10:50
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    I still haven't seen anyone make a good case that a line of credit (cancellable by the bank without notice) is adequate for emergency situations. – Snowbody May 5 '15 at 13:21
2

Let me offer what I did in a similar situation -

  • Before refi - $480K @7.625% PMT $3400, annual interest - $36,600 ($100K in bank @ close to zero interest)
  • Post refi - $384K @5.24% PMT $3085 (but 15 yr term) interest/yr - $20,100.

Two points (a) we were banking $20K/yr or so to the cash fund, 2 good incomes, and the ability to go indefinitely on just one of the 2. (b) A HELOC that was prime-1.5%.

The result was to mentally treat the HELOC as our emergency fund, but to enjoy the interest savings of over $16,500/yr for the $100K that had a sub-1% return.

When I first referenced this story, I came under criticism. Fair enough, it's not for everyone. Let's jump ahead. We owe $228K @3.5%. We had tapped the equity line for brief periods, but never over $20,000. When we lost our jobs, both of us, we had hit our number and are semi-retired now. Our retirement budget included the current mortgage payment, so we are in line for that dropping out of the budget in 12 years, and starting social security after that, which I did not include as part of the budget.

Note - when we lost our jobs, the severance was 6 month's pay, and we collected unemployment as well. The first 12 months were covered without tapping our retirement funds at all. So, to Nick's point (and excellent answer) our first line of defense against unemployment was this combination of severance and unemployment insurance.

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    How many years were left on your original mortgage when you refinanced? Both interest rates were fixed? – Snowbody May 5 '15 at 1:42
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    Both fixed. I went from 25 years left on a 30 year mortgage to the new 15. – JoeTaxpayer May 5 '15 at 2:16
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    I can't say anything against you, because it worked out well for you. But I have relatives that tried this and ended up losing their home. 2 good incomes both disappeared simultaneously. They were able to borrow from the HELOC, but the bank jacked up their interest rate and with no income and no savings they couldn't pay. In your case the refi greatly reduced the interest, your monthly payment dropped by $500 so that lowered the risk. – Snowbody May 5 '15 at 4:40

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