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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The goal for my emergency fund is one year’s worth of expenses. You can’t underestimate the importance of cash. Not only are you secure financially, but the peace of mind and the confidence you gain are invaluable.
I’m not a fan of tapping home equity as an emergency fund. It also just doesn’t make sense. Put your emergency fund in a money market at anywhere around 4-5%. This is about what you’d save by paying your mortgage down since the interest there is tax deductible. Also, your home is not a savings or investment vehicle. It’s part of your living expenses. Don’t confuse this.
Nice blog.
-limeade
http://fiscalmusings.blogspot.com
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I think that the amount of an ‘emergency fund’ is highly dependent on your risk tolerance and job stability.
If you’re in a stable job with excellent disability benefits, the chances of your income suddenly vanishing are extremely small. In this circumstance, using a line of credit as an emergency fund can be a good idea, since you’re confident you’ll have the income to pay down what’s borrowed.
If your job is less stable, or is more dangerous, you may want to have more cash on hand, in case you suddenly lose your income due to an injury or illness.
Personally, I think having a few thousand dollars readily available for emergencies is the minimum, but it’s probably unrealistic to have a full year’s salary available “just in case”.
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We are shooting for $1000, then we will lower the monthly contribution and apply more to outstanding student loan debt.
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It all depends what constitutes an emergency. After a natural disaster lenders may freeze or revoke a HELOC if they have reason to believe the asset backing the mortgage is devalued from the event.
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My e-fund is for 1500 a month (covers cobra plus normal expenses) for 12 months and thus is 18,000 dollars cash (errr, well in a money market fund).
Probably too large but it is what I keep. Mind you I have agressive investments also so this helps balance out some risk my portfolio.
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What kind of banker would give a home equity loan to someone who had no job? I don’t think I would want that risk.
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All this “how big an emergency fund”, “pay off your debt” stuff gives me a headache. I can’t figure it out. I’m not an accountant or investment guy. I’m a programmer. Soooooo I program and when it comes to finance I play stupid. To cover myself, and my stupididty, I don’t have any credit card debt. I have two car payments and a mortgage payment. I put 10% of my salary in a 401k. And I have an emergency fund with close to $50k. I feel these moves keep me covered until I can learn more about investing and all the stuff that goes with it.
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There is no one size fits all answer to this, and this is why there is such a wide range of recommended amounts. Most financial planners are taught that 3 months of reserves (6 months for a one-income household) is as a rule of thumb. The purpose should be to have cash available to cover short term costs, like waiting for the insurance company or while you look for a new job. If you are under insured (or self insure) you may want more. Home equity serves as a nice backup to a cash reserve should you deplete the whole reserve or temporary access part for a non-emergency. This strategy may be a nice compromise between an a large cash reserve and relying solely on a home equity line of credit.
Here is any easy (maybe even fun) way to “crash test” your finances. Make a copy of your Quicken, Money, Excel worksheet, or grab a blank check book register and simulate emergencies. Try injuries, illness, job loss, car gets stolen, day care evaporates, part of your house requires repairs, legal fees to mount a defense, whatever you can think of. You may need to do a little research, but this can help give you a sense of what your cash flow needs might actually be so you can plan accordingly.
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I have pondered over this question for a very long time. I am single and rent an apartment. Although I have a lot of money invested in my 403B, I do not have much saved for an emergency. When I do have a few thousand saved, something comes up such as car repair, or my computer crashes and I need to use that money that was intended to be used in case I lose my job. This shows me that I need to save more than just a few thousand dollars. I think we all need to think of the unexpected expenses that can pop up on top of our monthly bills because believe me, that money goes fast!
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My wife and I just sat down this past weekend to go over this question. With our first kid on the way now and us dependant upon my salary alone, we decided that having 5 months living expenses would be a nice cushion in case things go bad.
We keep that money in an money market savings account so we can quickly access it if need be. We also have no other debts except for the house note.
I agree with what most people are saying in that there is no single hard and fast rule here and it’s up to individual situations and risk tolerances.
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Personally, I don’t think I need a lot in an emergency fund, for a few reasons: I’m in a profession that lends itself easily to self-employment or work as a contractor, so if I lose my salaried position I could still find enough work to pay the bills fairly easily. Also, my necessary bills are relatively low–my mortgage payment is less than 10% of my gross monthly income, and I don’t have a car. My other big bill is my student loan payment, and I could get a forbearance if I absolutely had to.
There are always other ways to scrape up cash, and credit cards are a viable short-term option for groceries and utilities. In short, while I like to have a few thousand dollars in cash just in case, I think that would suffice for me if anything happened. A year’s salary sounds absolutely insane, and even six months’ expenses seems unnecessary.
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You friend’s advice about the HELOC makes perfect sense analytically. However, money isn’t just an issue of mathematics. Money is emotional.
Having a few months expenses sitting in a local bank conributes heavily to one’s peace of mind. Having to borrow funds when your car breaks down or you roof gets a leak only adds stress to the already stressful situation.
In addition, since it is so easy to borrow money from a credit card or HELOC, one’s definition of “emergency” tends to grow rather fluid over time. If you ever want to reach your financial goals, you have to get out of the vicious cycle of borrowing and paying back creditors.
As many others have already said, the exact amount of an emergency fund will vary depending on your needs. In our case, we’ve saved about two months’ expenses so far, but our goal is six months’.
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I don’t know. I have always wondered what is considered an “emergency”?
Is it limited to things like losing a job and needing to pay for regular expenses? Car breaking down- is that an emergency ( I just pay stuff like that out of regular expenses)?
Someone broke my car window a couple days ago and stole my CD player and some other things- is that an emergency? Again, something I will probably just pay out of regular funds that I don’t consider an emergency fund. Maybe since I live below my means I have a perpetual emergency fund that isn’t designated as such.
If I had a large emergency fund, I don’t think I would ever be in a position to need to touch it. An emergency would have to be something pretty catastrophic. I would have a difficult time deciding to use it.
I also keep my expenses low enough that I could get by with any menial job, pretty much. I mean if I had to I could find something to do within a couple weeks or a month at any time. maybe not something I really want to do, but something to cover house, food, utilities- the basics. I could cut off my cable, cable internet, cell phone,etc if I really HAD to.
I think this all depends on a combination of things such as salary/lifestyle expenses, insurance level, number of dependents, etc.
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Andrea’s classmate’s advice leads me back to a thought I’ve had for a little while now (and it’s not an original thought). The people with the greatest ability to fund a large emergency fund are the people least likely to need it.
For example, someone who is financially responsible and pays off their credit card each month typically has a large available card balance. If disaster hit, even if this person has no emergency fund, they have the card to function as one (albeit an expensive one). Someone who does not pay off their card each month typically won’t have an emergency fund either. The only difference is this second person probably won’t have the available credit to pay for an emergency.
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I strongly recommend NOT using your home equity line for an emergency fund. Going into more debt is not a great way to deal with an emergency. Relying on a HELOC for emergencies fosters an attitude of lax financial planning rather than a proactive, controlled approach.
It’s vital to start with at least a small emergency fund ($1,000 is a good recommendation) to get you through the minor emergencies. As you pay off your consumer debt, you can then use the funds that were going towards debt to build a more substantial emergency fund. 3 to 6 months feels about right to me (I think we’re currently at 3-4 right now).
I agree that there’s no magical amount. Even if you decide on 3 months of expenses, there’s still a lot of variability. Will you save 3 months of bare-bones expenses? Or 3 months of expenses with your current fully-employed lifestyle? I recommend going through a few emergency scenarios (losing a job, etc) and imagine how you would live. What expenses would you eliminate? Would you eat out? Then plan on saving enough to meet those types of expenses. If you don’t plan on changing your lifestyle in case of an emergency, you might want to save a little more.
There’s no need to get too technical when determining how much to save because it’s still really squishy. And just remember that any emergency fund no matter how small can provide substantial help and security. As it grows it just provides even more.
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I agree that on paper the HELOC idea has merit, but from a practical standpoint I don’t think it should be the primary emergency fund. I think it would make a better emergency emergency fund.
That said, most of my emergency fund is invested. I have some cash, but the likelihood of having an immediate need for 6-12 months worth of cash is pretty slim. I can divest my holdings as necessary and have cash within 3 days, which should be good enough.
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I’m going to agree with several others here that emergency reserves are often overdone. Now, I’m really talking EMERGENCY reserves — a dead car and the need for a new one is not in the same category of a lost job or disability. If you consider a need to make a sudden purchase such a car, refrigerator or replacement TV an emergency then you need more short term reserves.
Otherwise, you should simply keep a portion of your savings in non-retirement investments (so that you don’t get a heavy tax penalty for withdrawals on them). Yes, they’ll grow more slowly than tax-advantaged retirement accounts, but they can be accessed in a few days to a week or so at most. If you have funds like that, you can use credit cards while liquidating assets, then pay them off immediately upon receipt of your money so that you pay no interest.
If you really want to avoid credit cards entirely, just keep a week or two’s worth of cash in a savings or money market account.
If you DO wish to treat a home equity line as a source of emergency funds, make sure you establish the line of credit BEFORE an emergency arises. You want to be able to write a check on that account immediately — and your bank might not like to offer you such a line of credit if you are already in an emergency situation.
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Taking out a home equity loan when you become unemployed is not a good idea. You risk becoming both unemployed and homeless. Whether you call it an “emergency fund” or just “liquid investments” doesn’t matter, and there is no maximum amount.
Also emergencies are not just unemployment. They include medical emergiencies, natural disasters, etc.
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I dont believe racking up your credit cards is a good idea either as some of the previous enteries have stated.
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Home equity credit is DEBT, not “pulling money out”. You “pull money out” of a home ONLY when you sell it. Home equity lines of credit are a form of BORROWING money that MUST BE PAID BACK WITH INTEREST.
As long as that is clear, you can make an informed decision about emergency funds.
I bet the MBA who wrote that home equity credit is “pulling money out” probably lives hand-to-mouth on a six figure salary… little net worth. Most of the MBAs I know are miserable managers of their own money.
First, define “emergency”. Is it a car breaking down needing a repair that you had not anticipated? Then emergency funds of $1000 – $2000 might suffice.
If you define an emergency as “a job layoff with little or no serverance pay from a job that is highly specialized and not easily portable”, then 6 months or a year of salary might be in the ballpark of “enough”. That is how I define an emergency, from personal experience.
If you have other fairly liquid assets, such as stocks, you don’t need as much cash in an an emergency fund. The odds of a long stretch of unemployment coinciding with a significant loss of value of a well-diversified stock/mutual fund portfolio are small (though still possible). So count your taxable brokerage account assets.
In a real pinch, you can also tap tax-deferred retirement plans such withdrawing IRA funds early (with penalties and taxes) and borrowing from your 401(k) accounts, but those should be a last resort because of the damage those actions cause to your long-term plans and you get only a short-term benefit (funds until the emergency is over).
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I have 6 months net income in an emergency fund, but its in staggered high-yield CD’s (about 5%APY, 8-12 month terms). I earn interest, and money is always available if I need it.
I think HELOC is a bad idea, i dont like paying interest…good budgeting should mean you dont have to deal with it
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It is very much a personal decision in regards to risk and circumstances. I think having enough so that you can sleep at night and not have to sell investments or sell a home is realistic. Also, personally I keep less due to the fact that both my wife and I work, whereas if we were dependent on one job I would want a larger emergency fund. We are generally aggressive investors and likewise aggressive with our money and do not have too large of an emergency fund (~10k) but then again we have no credit card debt or mortgage payment that we are locked into.
-Thor
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What about sick days and vacation days. Does anyone consider that part of your emergency fund?
If you always have two extra weeks of leave isn’t that at least half a months worth of emergency money.
Then if you get paid two weeks behind your actual work days thats another half month of emergency cashflow. Your up to a whole month.
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This is one I struggle with, not so much from an “emergency” standpoint, but a “just living” standpoint. I’m not currently working and don’t expect to work again for quite some time. The challenge is trying to figure out how much I should simply have in cash vs. invested. 6 months of expenses? A year? I know that I’ll have to liquidate some of my investments as I go along no matter what, but how much to keep in cash for the time being is the challenge.
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Tapping a HELOC during an emergency? Isn’t that akin to putting gasoline on a fire?
If it’s an emergency, then things are stressful. Piling on debt in the form of a HELOC will only make things worse.
Having a few months in a short term account is all you usually need while you figure things out.
Other money can be put into stocks,MFs, ETFs, instead of an MMF(MMFs only gain 4-5% a year) and tapped as need be after that hypothetical first 3 months.
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The concept of having an “emergency” fund is a good one. While it is typically cast as being a liquid investment that covers X months of expenses, I think that definition is a bit narrow and that the vehicles one uses to create a cushion for such an emergency should be more flexible and (as suggested), align to each person’s individual situation.
For example, when I was early in my career my main focus was on maximizing savings to cap out on my 401(k), etc. Emergency savings were not a high priority for me because:
A) Expenses were relatively low and entry-level jobs were plentiful
B) I didn’t feel like I could “waste” money in a cash account while not maximizing my other investments like 401(k), etc.
C) My parents
As I grew in my career and got a family, house, etc, the ability to weather an emergency more of a priority:
A) Income harder / takes longer to replace
B) Increased financial responsibilities
C) Responsible not only for yourself, but others
However, as I am still not capping out on both my 401(k) AND Roth IRA, I still feel there is some trade-off. Therefore, I do not specifically have cash set aside for an emergency, HOWEVER, in case of emergency, I can:
1) Access revolving credit
2) Access home equity
3) Access retirement savings (loan)
4) Access other loans
Granted, that is not to say these options are “optimal”, etc. For example, many would say you shouldn’t tap your retirement accounts. Generally, I agree. However, the total dollars you have available to you are the same. Whether I invested $100 only my retirement account or split it $50/$50 between there and an “emergency fund”, the total is still $100. Arguably, which account(s) the $100 sits in is thus less relevant.
Don’t get me wrong, you have to weigh your options and consider the potential consequences (ex: a 401(k) loan where you pay yourself back is much better than a distribution where you pay taxes and are penalized).
My point is that we are talking about an emergency (which are hopefully rare) and there are a number of “emergency” options available…not just the cash one.
Generally speaking, I think you should be absolutely focused on maximizing wealth and making full use of tax-advantaged vehicles to do so. If those are maxed out, then perhaps you can think a bit more about having more ready cash available, etc.
Until then, I might offer the other emergency options I listed as viable (and for me, preferable) alternatives.
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I would say it depends on your risk tolerances and what you feel comfortable with.
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I have an emergency fund, but have never thought about how much it should be. I have an UK tax free account, ISA, which I put the maximum allowed in for two years which now gives me over 3 months salary.
I stopped putting money into my ISA account once we got an offset mortgage. Most of the spare cash goes into the offset to reduce the interest on our mortgage, however we can still access the money so can take money out if we need to, so I guess it works like an emergency fund as well.
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I have a multi-step emergency fund. The first step is about $1000 in an ordinary savings account. It is low interest, but I can get to it quickly. I then have about three months savings in a money market account. Better interest and it takes a couple of days transfer the funds back to my checking account. Any savings on top of that goes in longer term investments that make more than the money market account. I also make sure that my credit cards balances are low.
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I think there are two levels to emergency funds — the first being if your car needs a big repair or your heater/washer blows up, or (heaven forbid) you need a lawyer for some awful reason).
The other reason — what I like to call the “contingency fund” is to cover sudden income loss. Having been laid off with NO contingency fund and no severance pay, I think it’s really important to have at least a few months of LIQUID savings here — preferably more. My minimum comfort level here is 6 months. In addition I’d like another 6 months in something short term CDs or Bonds, something ultrasafe but hopefully earning a little more interest.
There’s no way in hell I’d rely on a HELOC as my emergency funds. When your emergency is over, at best now you have a debt to pay.
db
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Great article & lots of interesting comments. My own $0.02 are that while it may not make the most cents economically (pun intended!), having a 3-6 month emergency cash reserve in savings / CDs / money-market funds buys you significant peace-of-mind. My goal is to have 6 months of cash (savings/CDs/mmf) at my current lifestyle saved up. The anecdotes I have heard are that having that cash cushion will really make you feel free — give you options to quit your job if it gets too bad, or recover from a medical expense or unemployment or serious car problem. Keep maybe a month’s worth liquid, put the rest into a CD ladder to earn higher rates.
I don’t like the idea of using HELOCs, credit cards, or investments (stocks/mutual funds/etfs) as my “emergency fund” because those all have strings attached. HELOCs and credits cards you have to pay back with interest, so as soon as you have your emergency, the clock starts ticking and that’s just additional stress that you really don’t need. With investments, the big risk there is that your emergency comes at a time that’s not convenient to Mr. Market. What if your emergency need happened on 2/26? Over the next 2 weeks, the market had dropped between 4-6%, some stocks much more. And if we run into a serious bear market like some warn (or like we had in 2001), your e-fund will shrink even further. Diversification will help reduce the risk, but not eliminate it. The money I invest is money I don’t intend to need for at least years, if not decades. Selling off investments should be done carefully & rationally, since it can have a serious effect on your long-term wealth and your short-term tax consequences. In an emergency situation where I need cash, I would not want to be forced to make such decisions since I will not be thinking rationally with a long-term focus.
And of course, you need to decide what “emergency” means to you. And it’s probably more like a spectrum — ie unexpected job loss is an emergency right now. Car that is aging and will need replacement is something to start planning for so it doesn’t become an emergency. House flooding or major appliance dying — more things that may require an emergency fund withdrawal.
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i have built ALMOST a year’s worth of emergency funds.. i have no mortgage, therefore a HELOC would be out of the question for me
you can never have TOO MUCH saved for a rainy day.. i have it setup where i can easily take cash out for a necessity
checking (for everyday stuff)
then regular savings (my checking acct’s backup plan)
then ing direct (emergency funds)
then roth ira (last option.. can take out contributions if really needed)
it’s nice to have that freedom to know that if i wanted to quit my job and relax for six months comfortably, i could
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Just a note for taking out a loan on a 401(k) — I’m opposed to it, especially in an emergency. And there’s no point in planning on it as a fallback. When I was laid off they wouldn’t let me take a loan out of my 401(k) — I either had to roll it all over or I had to withdraw it all.
Of course, since I had NO EMERGENCY FUND, I had to withdraw it all. By the time taxes and penalties were taken out and I was re-employed, my entire retirement savings was now also gone. THEN to add insult to injury, two years later the IRS audited me for that year I was laid off and demanded an additional $1000+ penalty (including accrued interest of course) for a math error that resulted in me getting too much distribution and not enough penalty the first time around.
Retirement savings should NOT be the plan for emergencies. Just please don’t plan that way — using retirement funds this way is because of a failure to really plan.
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This is a very good debate. Just a few points to add.
1) I define an emergency as something that causes significant but temporary hardship on your normal cash flow arising from medical problems or job loss. Basically I can always afford the emergency in the long run, but I just don’t have all the cash right now.
2) It is ok to use a line of credit to help the cash flow out as long as you know and can handle that risk. I hate to have $10,000 just sitting anywhere in low interest when I can pay down my house (Note: I’m in Canada where we can’t deduct our mortgage interest).
I’ve personally been through a medical emergency with our first child and after 2.5 months in the hospital and over $15,000 in extra expenses we used a line of credit to help cover it for the short term. In less than one year we had it all paid off. I know that is a risk in using credit this way, but I would gladly do it again because it works for me.
CD
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I think emergency funds for many people are way overrated. If your finances are fairly healthy (and you’ll know if they are), I think it makes sense to keep a very small emergency fund in cash, and then use credit cards for your real “emergency fund”.
By definition, a true emergency should be rare. And for those rare occasions, it makes no sense to have a big stash of cash sitting around when you have easy access to credit.
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My emergency fund is about three months expenses and is also (like Kate Davis) in an ISA. I use my credit cards as an emergency emergency fund. I wouldn’t like to use anything like a HELOC as the risk of losing my home would cause severe insomnia.
My goal for my emergency fund is approximately 5 months expenses, which would cover living expenses and say the boiler breaking at the same time.
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See, I don’t have a problem using a HELOC as an emergency fund. If it was a major emergency (job loss), I would be forced to leave the country because of my immigration status. Therefore, I would sell the house. I have the HELOC open now, so I would just pull the money, pay the movers, and run. Since I have over 20% equity in the house, and the HELOC represents about 5% of equity (at today’s market value) I don’t think this is a terribly risky scenario. The proceeds from the sale of the house would cover the HELOC and I’d have enough cash to tide me over.
At that point, we also have the family as a back-up strategy. My husband’s parents are rather well off and have a large house where we could crash until recovered.
I do have liquid cash for breakdowns, repairs, new cars, etc. I don’t consider those emergencies though.
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@samerkand –
Here’s where I stand on relying on credit for emergencies. I’ve spent the last 2 1/2 years of my life sacrificing big time to PAY OFF my credit cards, more than half of which represents charges during an emergency layoff to survive. I’ve got another $10K to go. The last thing I’ll ever want to do again is rely on credit cards in that sort of cash flow emergency.
So — an 8 month layoff cost me thousands on credit cards and wiped out my entire retirement. Failure to be prepared, I counted on credit and retirement as my “plan” in the past. Please don’t make that mistake too.
db
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To me, emergency money would be for anything that would normal require going to the insurance company.
I myself don’t like the idea of insurance, I’d much rather have an emergency fund that could handle most everything. Especially smaller items.
The more money that is in my emergency fund the less insurance I would need from insurance companies.
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samewriter.. using credit for those rare emergencies might be a good idea for those who have thier financial situation under control
BUT we’ve already seen what credit cards do to people who can’t control their spending.. i just don’t see that as good advice
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$15K. That’s six months of living expenses. No reason why we have that amount. We don’t own a home though so HELOC is obviously out of the question.
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I tend to lean towards pumping it back into your mortgage (after ensuring a basic fund that can handle most emergencies). Keep in mind that an emergency can happen at any time, but the corollary to that is that an emergency MAY NOT (AND LIKELY WON’T) HAPPEN AT ALL. If some big emergency does come up beyond your basic fund, your money is still there in your equity, you just have to fill out paperwork to get it. And as a bonus you won’t be (as) tempted to dig into the money to go on vacation to Hawaii
But what if some big emergency doesn’t come up? Then you end up paying your house off early, and all things being equal, that means that no matter what, you will generally always have a roof over your head.
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I keep six months of reserves in a money market account and find this adequate for my families security. I do like clients to have HELOC’s avaiable for opportunities like a great investment or short-term major housing expenses. Using a credit line for weathering a set back is bad advice as this would increase your monthly obligations as you increased the balance. That being said if a credit line is the best you can do because your are incapable of saving money then use it sparingly. The challenge you may have is if you cannot save moeny then having access to your equity could be reckless as you may decide to buy a new car or take a trip etc…
Build reserves and build your sense of freedom.
Cheers,
Bryant Keefe
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Well, I don’t have a house… but I do have an emergency fund! I was able to get it over $1000 in about 5 months by putting 12% of my monthly net income into it. Now I plan on cutting back on that just a little bit and putting more towards paying down debt, one bill at a time.
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Thanks, everyone. I’m not sure my point / my classmate’s point came through here. Instead of having, $30k in an emergency fund, you throw that money (in one chunk) at your mortgage. If an emergency happens (which I pretty much only count as unemployment), you pull that same $30k back out. It’s debt that would have existed if you had the emergency money liquid somewhere else.
For example, you have a home worth $500k. You owe $330k on your mortgage. Instead of having $30k in an emergency fund, you put $30k against your mortgage, bringing it to $300k. You keep your mortgage payments the same. If an emergency (e.g. unemployment) comes up, you pull the $30k back out. You are in no more debt than you would have been if that money was sitting in a bank account. In fact, you’ve instead been avoiding 6% interest and putting more toward the principal, so you’re ahead.
The key here is that this money has been put down on your mortgage. It’s not just a home equity loan — it’s a loan that pulls out the money you put in for this purpose.
I should note that I live in Canada, where mortgage interest is not deductible. Also, we have unemployment insurance for a year, here.
I would never pull this money out for anything else. I do not consider roof repairs, car repairs or the like to be emergencies. I instead have a bank account with money set aside for these purposes. And I always have enough in the bank to pay my credit card in full every month. (I basically just use the CC as a convenient interest-free 3-week loan that gives me 2% back on everything.)
I don’t have a high ratio mortgage. Even if the local housing market drops 25%, I will still be ahead on my mortgage (and still have room to pull out that emergency fund).
I’m not worried about being approved for a HELOC — I’ve already got one that’s about 1/2 of our annual household income. The balance on that and everything except the mortgage is $0.
I just wanted to weigh in with these points, in case they change anyone’s suggestions. I would have been here sooner, but it didn’t work out.
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I had been claiming that it’s far better to use a Home Equity Line of Credit for almost a year now. I think Samerwriter had it right, “By definition, a true emergency should be rare. And for those rare occasions, it makes no sense to have a big stash of cash sitting around when you have easy access to credit.” Basically you are losing thousands and thousands in opportunity cost by not having this money optimally invested.
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They don’t change my suggestions. I think, frankly, that it’s a stupid idea to do this with a HELOC. If you ever pull it out, you’ll be subject to interest and you’ll have to pay it back.
Wouldn’t it be better to just have the cash sitting and ready for you? If you deplete it, you’ll have to build it back up again but there won’t be any interest.
I’m coming from the perspective of losing a job too — if you lose a job you want to be able to be as liquid as possible. Including being able to sell the house if you need to. And given the volatility in the job market, I think its foolish to assume a layoff won’t happen to you.
If you are going to pursue the HELOC idea, at least keep a portion of cash reserves — at least $5K or so. That way hopefully you won’t have to do the lunatic maneuver of tapping a HELOC because you need groceries and an interview suit.
I feel strongly about this because I’ve been through a layoff using stupid money. (and I don’t have a house now, partly because I’ve been through a layoff using stupid money)
db
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Well, we’re a two-income family, so there’s always someone to buy groceries and clothes.
Yes, there’s interest on a HELOC. But if you go, say, four years with continuous employment and then take out a HELOC and have to pay it back over four years, isn’t this the same as the four years of foregone mortgage interest?
And, if you have, say $200k equity in your house and you take out a HELOC for $30k, your equity is $170k. This is the same equity as if you had never paid down the mortgage with $30k in the meantime and you are still paying interest — over 20 or 25 years. So it shouldn’t keep you from selling your home.
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In my way of thinking, $10K in the bank earning some amount of interest is appropriate for an emergency fund. A CD or Bond is less desireable but ok. A HELOC is not. Why? Equity should not be used as a savings account or a line of credit. Period. I simply object to it.
IMHO, the reason the real estate market in the US is in trouble right now is partly because people take inappropriate liberties with their equity.
I ask again, if the idea of your mortgage sitting there is so onerous, why not keep $5K or $10K in cash, and pay the rest on the mortgage, so that if an emergency happens you have the cash and don’t have to do funny things with your equity.
A house is NOT a savings account.
db
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P.S. We have unemployment insurance in the states too, and I used it while unemployed. I got the maximum payment allowed, and it didn’t even make my rent payment. (I’d also exhausted my benefit before I got a new job.)
It’s great that you are a two income family — if you’re a consultant you’re probably not that far from having the ability to get a contract. Not everybody is in that position. I wasn’t, and though I’m very employable (great resume, mid-career, pertinent masters) I was laid off because the industry I’m in (IT) was in a downturn. So I had to ride out 8 months of no income.
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