Andrea writes with a question about emergency funds:
Does it make sense to keep six to eight months of expenses in an emergency fund? I always thought so. However, when I was doing my MBA, a classmate told me that emergency funds are unnecessary if you have a home equity line of credit. She said it makes more sense to use it to pay down your mortgage. If you lose your job, use the line of credit to tap your home equity.
In her opinion, you were doing nothing more than pulling out money you would have otherwise used for the emergency fund. Although you would have to pay interest on this money, she anticipated that the years of avoided interest on the mortgage would outweigh this. (e.g. if you didn’t have to pay 6% mortgage interest on $30k of your previous mortgage.)
Does this make sense?
I think that Andrea’s classmate has an intriguing idea. For many people, it may make sense to keep a smaller emergency fund, and to put the extra money into a mortgage (or into other investments). It depends on your risk tolerance.
When I wrote about how and why to start an emergency fund last summer, I noted that there doesn’t seem to be any expert consensus on how much one should keep on hand:
Some say you need save a year’s salary. Others believe $1000 is sufficient. Most advice tends to fall someplace in the middle.
How much do you really need? As usual, I recommend that you do what works for you. There is no one right answer. Examine your situation — your income and your needs — to decide how much you should save.
I’ve read a couple of books that advocate keeping only a small amount immediately liquid. These books argue that there are few catastrophes that would ever require you to come up with more than a couple thousand dollars on short notice. Insurance will mitigate many problems. For everything else, there’s time to obtain capital: to tap into home equity, to sell stocks, etc.
My advice continues to echo Dave Ramsey:
- Establish a $1000 emergency fund.
- Pay off your debt.
- Boost you emergency fund to cover about three months of expenses (more if you are risk averse).
How much do you keep in your emergency fund? How did you choose this amount?
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