April 15, 2014, 5:00 am

What is The Best Emergency Fund?

by: The Financial Blogger    Category: Personal Finance
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It may sound like a financial planning topic but this is only common sense: you need an emergency fund. If you are young and starting your career; you need an emergency fund to cover for a job loss. You have a young family and a mortgage; you need an emergency fund to cover a broken washing machine. You grow older, don’t have any debts; you still need an emergency fund to cover for healthcare. As you can see, all your life, you will need an emergency fund.

 

HOW MUCH SHOULD BE IN AN EMERGENCY FUND?

 

In financial planning, we often talk about 3 to 6 months worth of salary. If I look at my own situation, this would mean having $16K to $32K. This is a huge stack of cash to be sitting in my bank account doing nothing. Worse than that, if you are like me and have a young family, you know all to well that your money is going towards groceries, activities and clothing. Therefore, there isn’t enough money left to #1 pay off your debt, #2 save for retirement, #3 pay off your mortgage and #4 build an emergency fund.

 

SO WHERE DO YOU GET THE MONEY TO FUND IT?

 

We will all agree that we need an emergency fund. If tomorrow I need $5,000 to repair my house or because I’ve lost my job, I don’t want to put this money on my credit card. The problem is often finding the money to build your emergency fund. Most people can’t save more than 1-2K per year (besides all other obligations). So how can you save 3 to 6 months worth of income?

 

This is when you have to think outside the box and leave the savings bank account to frugal people. I will never be able to save that much money in my bank account, so I’ve figured out other ways.

 

 INSURANCE

 

Huh? How can spending more money on an insurance contract assure that I won’t need an emergency fund? By taking disability (or salary) insurance. This type of insurance kicks in when you are unable to perform your work. If you are depressed, ill, or break your leg, you can use disability insurance. This will compensate a part of your salary and will help you avoid falling into credit card debts. I have a pretty good plan insuring 70% of my paycheck in the event of disability. This would be enough to cover most of my expenses already.

 

Disability insurance is also offered on credit products to cover your payment (for a mortgage as example). Unfortunately, it is not cheap.

 

HAVE ANOTHER SOURCE OF INCOME

 

I just read an interesting take from Dividend Mantra saying he would rely partially on his dividend payoutsif he were to lose his job tomorrow. Last month, he made $700 in dividends and this is enough to cover his rent. Not bad, huh? In my opinion, having a second source of income is probably the best solution to fund your emergency fund. The money doesn’t sleep in a bank account in the meantime, but will quickly take care of part of your bills if you lose your job.

 

My dividend income is all in a registered account for tax purposes. This is why I can’t use Dividend Mantra’s technique. However, I do have my online company generating several thousand per month. If I was going to lose my job, I would not go for another one. I also have my employer stocks which fluctuates from 1K to 5K most of the time (this is because I keep selling them each year to pay off other debts).

 

HAVE A LINE OF CREDIT

 

If I have an unexpected one time purchase to make (like a washing machine or an expensive car repair), I also have a line of credit. I could put a few thousand dollars on this as well if I had an urgent need for money. I would rather use a line of credit as emergency fund than having 10K or 20K sitting in a bank account earning 1%. This idea is simple; you are losing money if you use real cash to fund your emergency fund. You could save interest on your debts or make money investing if you would use this emergency fund instead of having it sleeping in a bank account. This is why I think it’s better to pay off your debt but leave a line of credit open and available on the side for emergencies. If you don’t use it, the line of credit is free of charge!

 

HAVE AN EMERGENCY LIST INSTEAD OF AN EMERGENCY FUND

 

I often talked about the importance of having a plan B on this blog. The idea of a plan B is to get a way out of financial trouble in case of an emergency. When something bad happens in your life, your emotions put you on the edge and your head doesn’t think right. If your emergency plan is already drafted, you only have to look and follow it. No second thoughts, no hard decisions to make. They were all done in the plan when you had your mind set to think about it.

 

The good news is building an emergency list is not too hard nor complicated. It only takes a few minutes of your day and it can be revised on a yearly basis to make sure all your solutions are still in place. Here’s mine as a reference:

 

#1 70% of my income in case of disability (insurance)

#2 An average of 3K quickly accessible through my employer stocks

#3 A side business where I could rapidly withdraw 3K per month to sustain my lifestyle

#4 An average of 3K available on my line of credit to withdraw at anytime

#5 If I was going to lose all my income source for a while, I still have 50K in a registered account where I can withdraw money from it but pay taxes

 

*If you want to read more about this, I’ve already described my plan B here and there.

 

Do you use cash to fund your emergency fund or do you use other means? What do you think of my plan?

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Comments

We have disability insurance through our work, but this would only kick in if I became disabled, it wouldn’t help if I lost my job. Apart from that, we have our credit line which we’ll be using for a roof job this summer.

The second stream of income is nice, although sometimes the timing of payments from various sources can fluctuate wildly – which can be frustrating.

The way I see it you can use a credit card for 21-30 days interest-free. If things don’t sort themselves out by then you can fall back on a line of credit to reduce your interest rate down to 3-4%. After that I would look to withdraw from investments.

by: The Financial Blogger | April 17th, 2014 (6:47 am)

You can also take a 0% credit card for a few month if you really need room to breath. On the other side, this is a short term solution (9 to 12 months).

by: RICARDO DI VINCI | April 23rd, 2014 (11:18 am)

How much to keep liquid. Depends on your outflow. If you make $3K mth you probably spend less than someone pulling $6K mth. What you need to budget is the necessities of life. Food, heating/electricity, communcations, roof over your head (mortgage,taxes, etc) tranport and if you don’t live in a nudist camp (unlikely in Canada in winter) clothing. Aside from that restaurants, movies. and, yes, even vacations are not “necessities” of life. Figure out your necessities and you will have a realistic overview of what you really need to survive a bit of bad luck.
A lot of people do not understand or appreciate the value of money think it is made to be spent as soon as it is available. Thye are hte ones who have trouble balancing a chequebook and living within their means – spend less than what you bring home.
Is credit necessary? Yes but as little as possible.