September 25, 2007, 7:00 am

There are no needs for an emergency fund

by: The Financial Blogger    Category: Financial Cliché
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You are being a good man; you decided that you will take care of your personal finance. The very first thing you realize is that you require help to manage your investments, debts, insurance, budget and so on. Then, you decide that having a personal planner or a financial advisor would be a great help to create wealth. I can guarantee that they will talk to you about creating an emergency fund.

emergency

While I am definitely not convinced that you need a financial consultant to create wealth, I am even less convinced that an emergency fund is something useful! It is definitely a financial cliché.

What is an emergency fund anyway?

Here’s a definition of an emergency fund: it is a highly liquid part of your assets invested in non-risky investments in case you need money to cover for a job loss or unexpected expenses. This money should remain dormant unless a financial catastrophe strikes your wallet.

This money is a waste of potential return

Obviously, if you invest in a low risk financial product, you are wasting your potential return. As an emergency fund requires to be available on the spot, most funds are deposited into a money market account or a savings account. In both case, you can rarely expect more than 4,5%. Therefore, this money could have been used to pay off debts that may bear a superior interest rate or you would have simply invested this money into something that is more profitable. Since higher return is often meaning higher risk, it defeats the purpose of an emergency fund. The goal when you invest your money into an emergency fund is primary to protect your capital. On the other side, if you are 30, you could loose a good 30 years of good returns.

There are alternatives

My favourite alternative is the line of credit. In fact, this financial product doesn’t cost a penny if you don’t use it. You can withdraw money from your line of credit at any time, so it is very liquid and the available limit is stable. Having a 20K flex line would be the best alternative to having an emergency fund. In fact, it is more convenient as you don’t have to put money aside to build a reasonable fund. The money is available 24/7 upon the opening of the account.

Another solution is to build equity in your property. Banks will more likely lend money if they have collateral. Therefore, if you can give your property as collateral and refinance your mortgage, you will be able to access enough money to survive for three to six months.

What is the difference between borrowing or having liquidity

This is where it gets interesting. Normally, an emergency fund is used to cover for regular expenses for a period of three to six months. Let’s say than an individual’s monthly expenses are 5K and that he would be able to borrow this money at 10%. If he takes off the full amount (30K for six months) on the very first day, he will have to pay $250 per month in interest until he can pay back the full amount. This would be the real cost of borrowing money instead of keeping 30K into a savings account. However, you have to figure out how much time it will take to actually gather this sum of money and how much could you earn from it if you would have invested in the market.

I think it is a small risk to take when you think about how much you could earn on the market over time. If you invest money already, you probably have a part of it invested in low risk investment. Why don’t you use this money if anything bad happen? Worst comes to worst, you will still have your line of credit to cover for the unexpected.

 

 

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Comments

Man, you stole my thunder. This was one of the pieces of bad financial advice I was going to write about. Now I’ll have to wait awhile.

I totally agree. If you have the ability to secure cheap credit then leaving some available is better than holding cash as an emergency fund.

Times when an emergency fund is a good idea is for people who are leveraged to the hilt or just have very tight income. These people absolutely have to save a buffer somewhere.

The purpose of an emergency fund is dodge the risk of losing things like houses and cars when bad things happen like job loss or sudden expenses. However you cover that risk is fine; it doesn’t have to be cash.

by: The Financial Blogger | September 25th, 2007 (1:30 pm)

Hey CR, you might find more inspiration from my post about the bank of non-sense 😈

I tend to disagree because it depends on the context of why you have to use an emergency fund. If you lose your job and you work in a high demand field, then, sure, drawing down on your LOC isn’t a big deal. Emergency funds also mean less to employees who can draw down on EI; self-employed has no such benefit and an emergency fund is, in many ways, a fund for both their personal and business lives.

But, what if you get sick and you cannot go back to work for a long period of time and you have neither CI or disability insurance? You are digging yourself into a larger hole by drawing on a LOC and paying interest on it.

An emergency fund is unnecessary only if you drill down at the context and say (i) the emergency is short term (ii) you have insurance in place (iii) you are disciplined about debt management. in this context, I agree with you. But as a blanket statement, its dangerous to say an emergency fund isn’t needed.

Banks, as you know much better than I do, are cash flow lenders. It is difficult, based on an experience from a friend of mine, to refinance your home if you have no job (remember what’s the first thing a bank asks when you request a loan- its not what is your net worth but what how much do you make?) A B lender may put a 2nd mortgage on your home but even they need assurances you will have some cash flow to meet mortgage payments.

I may blog on this topic and send a trackback to you. Thanks for bringing this up.

by: The Financial Blogger | September 26th, 2007 (12:00 am)

TMW,
I do have a problem with the utility of an emergency fund because its primary objective is to cover temporarily (this is the important word) a loss of income. Where building this emergency fund for 6 months would take you forever, a simple visit at your bank when your finances are healthy would solve the problem. If you have to rely on a line of credit for a period between 3 to 6 months, you may be able to recuperate this sum of money in a short span of time once you are back on your feet.

The potential loss in yield, sacrifices incurred during the saving process and the fact that you might never need this emergency fund in your life minimize the impact of the interest paid on the line of credit.

I agree with you that for self employed individuals, income is not stable throughout the year and may requires additional funds several times from month to month. Then again, a line of credit is the perfect product for this kind of situation as it was designed to compensate for unexpected expenses.

You would be better off in investing into a disability insurance than saving money for an emergency funds. I might be wrong as I didn’t do any calculation, but my guess would be that it is probably cheaper.

I have to agree with you on the last point. With banks, you are always better off asking for credit when you don’t need it. Otherwise, things are getting a little bit more difficult!

I appreciate your comments and I strongly expect this post on your blog. It is always great to share different point of views.

Cheers,
FB.

I have just started building a liquidity float fund. Although, it doesn’t seem to meet the definition that you stated as an emergency fund. I think this is more for bigger purchases that we make rather than an emergency fund, but could be used as one if I was out of work for a little while. The idea is to save for bigger purchases and then continue to rebuild the fund as these always come up in life – cars, renovations, appliances, vacations, repairs …

I think a 10-20,000 cash float is nice to offset bad debt from purchases on a LOC, bad loans and credit cards. The idea is to get ahead of the buying curve with a savings curve.

To me “No debt is better than good debt”. Even if you cashed in some investments to buy a car and then borrowed back the money to purchase new investments, You may get back your 40% tax back but the Bank is still getting the other 60%.

Or you take the immediate tax hit on the investment and losing the potential gain there. Also, this forces you into a less risky portfolio as there would be some expectation of taking the money out anytime in the near future. Again hampering your gains.

Just my 2 cents.

by: The Financial Blogger | September 26th, 2007 (6:04 pm)

Quentin, I think you bring up a good point that savings could be use for specific purposes such as cars, reno’s or other project. If you are planning on buying a car in three years, you definitely do not want to invest in high risk investments. In the meantime, this growing savings account can be used as an emergency fund.

However, I think that “no debt” will bring a great piece of mind but will definitely not bring wealth. Leveraging is your strongest tools to open the big golden door that leads to financial freedom 😈

I agree that “conservative” leveraging is an excellent strategy for using other peoples money in order to create wealth. I’m just not confident that it scales down as well as it scales up for strategies like the Smith Manouvre.

I guess I need to see the numbers.

by: The Financial Blogger | September 27th, 2007 (6:49 am)

Quentin,
Then, I invite you to follow my SM progress in the SM category of my blog. I post an monthly update on this investment strategy. I will follow-up your comments with another post on leverage because the SM is a very conservative way to leverage (as oppose to take a 200K investment loan).
Thx for your comments!
TB.

[…] Financial Blogger from The Financial Blogger presents There Are no Needs for an Emergency Fund. Very […]

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When you line of credit, do you mean home equity line of credit? If that’s the case, only homeowners can have a HELOC. If you don’t own a home, tough luck. Unsecured personal line of credit is pretty expensive, close to credit card rates. It’s like saying your credit cards are your emergency funds.

by: The Financial Blogger | October 1st, 2007 (1:42 pm)

Finance Buff,
in fact, you can get a personal line of credit for P+2 or P+3 in Canada, I don’t know about the states. It is obvious that the best case is to get a Home Equity Line of Credit. But the personal loc would work just fine.

I think it depends on the amount you hold. I think 6 months is overkill, especially given the various options of lower liquidity which wouldn’t take a full 6 months to attain. However, I know a lot of people that live month to month and they get burned, have to mooch off parents, etc as adults when the unexpected happens. I can’t tell you how many times, I’ve been able to save a good deal of money by offering to use cash or write a check on the spot if credit card isn’t accepted. I always hold about 2 months worth in the event of job loss, unexpected financial events, etc. If anything, it’s partial diversification so I don’t have 100% tied up in equities, right? I haven’t gotten around to it, but I’ll have to do a post soon on a recent win with a furniture dealer where this saved me a several hundred bucks.

Dan at edf.

by: Ted Valentine | October 2nd, 2007 (10:22 am)

My grandma always told me “don’t take financial advice from broke people.” I love my grandma.

by: manu singh | October 2nd, 2007 (12:50 pm)

I like the idea . But i will still keep 2 month of expenses in savings account . i have faced unexpected expenses couple of times . In those situation i signed up for 0% apr offer on purchases and balance transfer and carried balance and paid off after few months . To use the credit card strategy you need a good credit history though .

by: The Financial Blogger | October 2nd, 2007 (8:26 pm)

Hey Ted,
You should ask to broke people how they got broke; some of them might have great advice to give to you anyway 😉

Many, the 0% apr is a great idea! it’s pretty cheap and very effective!

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