Emergency Fund Basics

How to best Prepare For Unexpected Events

In life, nothing is certain. That’s why one of the first basics of a financial plan is having an adequate Emergency Fund. However, emergency funds come in all shapes and sizes and can be accomplished through a variety of methods. We’ll explore some of the most common elements of emergency funds below as well as some creative planning strategies we’ve employed to assist clients in feeling financially ready for anything.

Emergency Fund 101

An emergency fund is really nothing more than a pool of funds you have access to in an emergency. This can be a one-time event such as an unexpected medical bill, or a longer timeframe event like a 6-month period of unemployment. Most financial experts agree that you should have access to a minimum of 6 months’ worth of Non-Discretionary Expenses – this means any expense you can’t cut out of the budget like rent/mortgage, utilities, food, etc. must be accounted for.

Some risk-adverse individuals may wish to keep an even larger emergency fund on hand, but we generally agree that somewhere between a 6-12 month expense buffer is perfectly adequate for most individuals.

What’s in an Emergency Fund?

Some people believe that your emergency fund must be sitting in your bank, ready to be spent at a moment’s notice. However, life very rarely works that way! Bills take time to be sent via mail, so in reality individuals have some time after a major expense to move funds around to cover the cost.

It’s also common to see individuals losing out on significant potential income by employing a cash-only emergency fund strategy rather than considering higher interest-bearing options. Most people have access to several avenues of liquidity that we would consider to be an emergency fund asset, and some of them have substantial advantages to a cash-only strategy. Below are some examples:

Cash

Whether in a bank or a safe at home, cash is the most readily-available and liquid asset to cover emergencies.

Money Market

Money market funds are a great alternative to cash due to their liquidity and value stability, but have the added benefit of earning substantially higher rates of interest than most bank accounts.

Short-Term Bonds

Short-term treasury bills and other similar fixed-income instruments also exhibit excellent stability over time but typically out-earn bank interest. Readily convertible to cash to cover expenses.

CDs

Certificates of deposit are an interest-bearing instrument that can be acquired via your bank or in your investment account. They are typically very liquid, but some banks will charge you a portion of the interest earned to liquidate – generally not the case when a CD is sold in an investment account.

Credit Card Limits

Credit cards are another great source of liquidity. While we don’t recommend relying on them as a long-term source of funding due to high interest rates, they are a useful stopgap given the ~30-day billing cycle delay and also have certain benefits such as cash back or points.

HELOC

If you have sufficient equity in your home, a Home Equity Line of Credit can be an excellent source of funds in a pinch. Generally charging far lower interest than personal loans, the HELOC only accrues interest when tapped and is useful for significant costs – the HELOC can also be refinanced into a mortgage later if required.

Margin Loan

This is a line of credit secured by your brokerage account – IRA and 401(k) accounts cannot be used as collateral. A margin loan allows investors to borrow funds from a custodian, such as Charles Schwab, without disturbing the investment process within the account.

No securities are sold to provide the liquidity. This allows the investor to determine whether to liquidate investments at the time of the expense, or simply pay interest on the loan until the securities in the account are at a price where the investor feels comfortable liquidating.

As with any creative financing strategy, it’s important to understand the benefits and risks of using margin. However, margin can be a simple and efficient way to cover short-term liquidity needs without a cumbersome and expensive underwriting process.

It’s clear that there is no such thing as a one-size-fits-all emergency fund strategy. Each investor’s unique situation and needs must be accounted for.

For instance, homeowners may wish to employ a HELOC-based strategy as part of their plan while a renter would not. An individual without a brokerage account balance sufficient to have margin wouldn’t be able to use that as a source of funding. Ultimately, it’s important to rely on a qualified professional’s advice in the creation of your unique strategy that accounts for permanent and temporary emergency funding.