Do you have an Emergency Fund?
To me, an ’emergency’ is usually something like a problem with the house or car, losing/changing jobs, or a health problem. These are all real and can all take significant chunks of cash …
… but, if you can reasonably forecast their likelihood up front (i.e. you have a family member with a known or suspected ‘condition’; a crappy house/car/job; etc.), then they’re not ’emergencies’ – in my book, they are ‘time bombs’ – and you should be budgeting/saving a specific amount to cover the expected cost + a margin of safety, as best you can.
They are not ’emergencies’ for the sake of this post …
… they are the unfortunate realities of your life and you need to prepare for them properly – even if it has to come at the short-term ‘expense’ of your Investment Strategy.
No, what I am talking about is the ‘lucky majority’ who have good jobs, homes, cars, health – besides partying VERY hard to celebrate our good fortune – how much of an Emergency Fund should we have?
1 month? 3 months? 6 months? More?
OK, let’s bust the myth of keeping 3 to 6 months cash sitting in an Emergency Fund!
Never had one, don’t want one … and, if I was to keep one, it would have 2 years of income sitting in it (in a mixture of redeemable bonds, cash in various currencies, and gold coins/bullion) so that I could run and survive “when the [insert disaster of choice: Russians/Arabs/WWIII] come”.
So, does that mean that I don’t have cash?! Hell no … it’s just that it’s not for emergencies … it’s for investing. And, as I said, when I was still building my wealth, I never kept an emergency fund.
We did keep cash surplus for unexpected bills, etc. but never more than a month or two of income … at least, not for long … here’s why:
What happens if no emergencies crop up in the next 5 years?
If you had $10,000 sitting in an Emergency Fund (e.g. CD’s) you would have earned nearly $1,700.
If you had $10,000 sitting in an Index Fund you would have earned nearly $3,500.
What happens if no emergencies crop up in the next 10 years?
If you had $10,000 sitting in an Emergency Fund (e.g. CD’s) you would have earned nearly $4,200.
If you had $10,000 sitting in an Index Fund you would have earned nearly $10,000.
What happens if no emergencies crop up in the next 20 years?
If you had $10,000 sitting in an Emergency Fund (e.g. CD’s) you would have earned nearly $11,000.
If you had $10,000 sitting in an Index Fund you would have earned nearly $33,000.
Get the picture …. that’s a $22,000 ‘premium’ to cover a possible emergency!
It gets better ….
What if you had committed that $10,000 to a deposit on a $100,000 house? Over 20 years, it would have increased your Net Worth nearly $200,000 !
So, are you willing to pay a $200,000 premium for an insurance ‘insurance policy’ against an emergency?
But, what would I do if an emergency arises:
1. If it’s a ‘planned’ emergency of the kind that I mentioned before, I would borrow against the house, or sell down my stocks ahead of time and put the money aside well ahead of expected use.
2. If it’s an ‘unplanned emergency’ then I would already have taken a HELOC against my home – and, in the event of such an emergency, I would simply draw against it, and put in place a plan to pay it back.
Sure it will cost interest, but that’s the gamble that I took – even if it takes me 5 years to pay it back, the interest bill will pale against the increases that I made by investing those funds (and will continue to make, when I get the debt paid off and my feet back on the ground).
Warning Advanced Strategy: What do I do?
Well, I always pay cash for my houses, but then I take out as big of a HELOC as my wife and bank will allow me (usually more than 50% of the equity that I hold).
Then I draw down the full value of that HELOC and invest in individual stocks (an Index Fund is a fine alternative for the purposes of what we are discussing) … if I happen to need the money for an emergency, I sell off all or part of my investment and divert the HELOC borrowings to that use. So far, I haven’t had to.
Loss on the stock? That’s market timing, which is why this is an ’emergency strategy’ only …
… the key is not to take a certain hit on your finances for the possible loss in an emergency. Equally, it means not sticking your head in the sand, and having a contingency plan in place i.e. a way to deal with emergencies if they do crop up.
At last – someone who agrees with me on this issue: http://aprivateportfolio.blogspot.com/2006/08/emergency-funds-are-wasteful.html
While there may be people who would be unable to fund an unexpected expense from other investments or a loan and who would be hit hard as a result, for everyone else, I consider an “emergecny” fund a waste of resources.
I’m confused. You pay cash for the houses, then take a HELOC? If memory serves me, you never hold more than 20% of the house value, AND mortgages interest rates are usually lower than HELOC’s interest rates AND mortgage interest is also tax-deductible (at least to me)whereas the HELOCs may not be (seem not to be by what I’ve read). What am I getting wrong here? (and thanks for tackling this subject!)
@ Di – a mortgage is ‘permanent’ … a HELOC is ‘temporary’ (you can turn it off/on, decrease/increase as you like). Different horses for different courses … worth a f/u post, don’t you think?
Aren’t HELOC rates above 1st mortgage interest rates? Or if you have no first mortgage you can get a lower rate? Diane: At AJC’s level mortgage interest on owner occupied property is not tax deductible I think, while interest on investment loan is. Which might explain the HELOC strategy?
@ Moom – You are partially correct: at my level, tax deductibility of the home loan portion is limited. Having said that, I look primarily at UTILITY, which I will address in an upcoming post.
Adrian, Thanks again for turning conventional wisdom on its head and helping me to think outside the box. Not sure If I will be able to convince the wife on this, but I already have some of my emergency fund in still liquid but more riskey investments, but the good thing about a balanced portfolio is you usually have something ready to sell anyway to balance it back out.
Diane, I think Adrian’s 20% rule is not to have more than 20% of your NETWORTH in ONE investment (i.e. your house) versus having 20% equity.
I hate having loads of cash sitting around earning less than the rate of inflation. And I consider 3 months of expenses for me to be loads of cash. Plus I have tons of liquidity in the form of a total stock market index fund. This is from where I have drawn money when I totaled my car unexpectedly (ins only covered half the value of a comparable newer car), when I needed a down payment for real estate purchases, etc.
That has worked great over the last 5+ years of a bull market. But 2 weeks ago I was presented with an unexpected real estate investing opportunity, which I jumped on. I was of course going to put 20% down (to minimize the rate, avoid PMI, be conservative, etc). Then the market began its tumble. I was AGONIZING over the loss (it would still technically be a gain to sell, but still it sucks to sell at a market cycle low).
Luckily for me I have a wealthy and generous grandfather who volunteered completely unprovoked to lend me the money for the down payment rather than have me sell stocks at a cycle low. He has plenty of money sitting in bonds and cash that he doesn’t have any better use for, I suppose, than to thrill a granddaughter with a 2.5% loan.
I would never have counted on such generosity and would have still sold my funds for this RE investment, but come to think of it having family members with money is kind of an EF in itself. Even if I lost my job it’s not like my parents, grandparents, siblings, or even my myriad of extended relatives (who aren’t all wealthy by any means) would allow me to go hungry or miss mortgage payments. Naturally I wouldn’t allow them to do the same either, though.
@ Meg – I like your strategy – the first half: having a generous grandfather is great (can I ‘borrow’ him?), but it looks like you would have cashed out anyway, which is the important point for the grandfatherless-rest-of-us … let’s explore further (stay tuned).
Pingback: Is this what a transition to Money 201 should look like? « How to Make 7 Million in 7 Years™
Pingback: Different horses for different courses … « How to Make 7 Million in 7 Years™
Pingback: Why the ‘wrong’ people are rich! « How to Make 7 Million in 7 Years™
Pingback: More on Emergency Funds … « How to Make 7 Million in 7 Years™