Emergency Fund Alternatives
Hello again $wanigans! Thanks for checking back in with The Green Swan. Today we are going to continue our discussion on emergency funds. In a previous post titled Rainy Day, Rainy Month or Rainy Year I discussed how big of an emergency fund is necessary and many common considerations we each need to make. We’ll expand on that earlier post with more today regarding the opportunity cost of maintaining an emergency fund and alternatives to emergency funds. Lastly, I will end today’s post with details on my “emergency fund”.
The Opportunity Cost
Dave Ramsey suggests maintaining an emergency fund in a separate, stand-alone bank account (e.g. checking or money market account). In the previous post on emergency funds, I disagreed with Mr. Ramsey that the emergency fund should be able to cover three to six months’ worth of expenses. And this week I am disagreeing with him that it should be held in a separate account.
Let’s establish the opportunity cost before we go into alternatives. Mr. Ramsey is suggesting we hold $15,000 or more in a bank account earning no interest. With good alternatives to an emergency fund, we could rather invest this money in the stock market with expected long term returns of 8% or a stock / bond mix returning ~6% or so. Since I’m a fan of investing to win, I will use the 8% return as my opportunity cost.
Investing $15,000 at 8% would accumulate to over $22,000 in just five years, resulting in an opportunity cost of over $7,000! Over ten years, that account would grow to almost $32,400, or a $17,400 opportunity cost.
So thanks, but no thanks Mr. Ramsey, I can do better than just letting my $15,000 sit in a 0% interest checking account.
Alternatives to an Emergency Fund
Alternative #1: Open a Taxable Brokerage Account
Instead of setting aside $15,000 in a checking account, invest it in a taxable brokerage account and put your money to work. You could buy stock or bond index funds and keep it simple. I note there is a risk of losing money when investing in stocks or bonds, but over the long term it will be your best option.
Another concern may be that it is not liquid to get access to cash in time of need. I would refute that as a misconception. If you needed access to cash in time of emergency you could sell your index funds immediately, the sale would settle in one to two days, and you could then transfer that money back to your checking account same day. You could easily get access in less than a week and as quickly as three days.
I opened my brokerage account at Firstrade over ten years ago (after realizing how expensive Vanguard’s brokerage account is) because of its reputable online platform and low costs / trading fees.
Alternative #2: Open an IRA Account
If you are already investing for retirement, you may very well have an IRA account open already. If so, remember that you can always get the principle contributed to an IRA back without penalty (or tax in the case of a Roth IRA). Any gains you have made in an IRA cannot be liquidated without penalty, but the initial contributions you made can be. There are exceptions to this rule though, including penalty free withdrawals for medical expenses; however, I’d advise speaking with a tax professional to help determine the amount of penalty free withdrawals that can be made.
As mentioned above, my brokerage accounts are with Firstrade. Between my wife and I, it is nice having all our accounts in place which include five accounts total (each having a Roth and Traditional IRA and my taxable brokerage account).
Alternative #3: Open a Home Equity Line of Credit
If you are a homeowner and have been diligently paying down your home loan, you may be able to access that capital in time of emergency by opening a home equity loan. In my mind, this is one of the primary benefits of owning a home. This process can be completed easily online through LendingTree, one of the most popular and reputable companies out there. Or for the older homeowners (usually 60 or 65 years old), looking into a reverse mortgage could be another option to see if you could qualify. A reverse mortgage or home equity conversion mortgage (HECM) is a type of home loan that requires no monthly mortgage payments and instead defer payment of the loan until death, sale or move out.
The downside to a home equity line is that there will be fees and expenses related to accessing your home’s equity (appraisal, application fees, lien searches, etc.), but it is nothing compared to the cost of letting your money sit idle in a checking account (with the significant opportunity cost outlined above). Another downside is that it will take a few weeks before the money is ready. However, if you need more time and you have a forthcoming emergency bill for medical costs, home or car repairs, etc., you could consider putting it on a credit card and subsequently paying the credit card off in full when that bill comes due. This would help buy you some more time to get a home equity loan established.
Alternative #4: Personal Loans
A personal loan would be another decent option in time of emergency. While this may carry a higher interest rate than a home equity loan since it would be unsecured (a home equity loan is secured by the house), it will depend on your income / credit score and you could still get a competitive rate. Personal loans can be accessed from basically any bank, including LendingTree, with applications online, approvals within minutes, and funds available same-day. Being approved for personal loans with bad credit when you have an emergency can be a challenge. Learn more about how to improve your credit for better chances of approval by visiting The Ultimate Guide to Credit Repair (2017 Edition) – AAACreditGuide.
From purely a financial and cost perspective, I would still consider this a better alternative to Mr. Ramsey’s suggested bank account.
- Let’s assume you need to $10,000, you borrow this via a bank personal loan, and it calls for fixed interest only payments of 10% (I’m assuming a conservatively high rate, a lower rate would be possible with a good credit score) with principle balance due in 3 years. This would result in total interest expense over the life of the loan of $3,310.
- Alternatively, assume you listened to Mr. Ramsey and parked $10,000 in a checking account earning you 0%, with an opportunity cost of 6% invested in a mixed bond and stock brokerage account. And of course you don’t know when you would use it, so it sits there indefinitely. But over just 5 years of idleness, you would have incurred an opportunity cost to the tune of $3,382.
My “Emergency Fund”
As you know from the previous post on emergency funds, I target a minimum of $3,000 in liquidity (checking and savings account balances). While I maintain a checking account at a large national bank so that I can conveniently get access to it anywhere, I prefer to keep as little as possible in it. If you can’t tell, I really dislike having money sitting around idle, so you probably aren’t surprised to hear that I maintain my savings account through an online high-yield savings account. This offers a better interest rate than you can find at typical brick-and-mortar banks.
Online savings accounts typically link easily to traditional brick-and-mortar checking accounts. This allows me to conveniently transfer money back and forth when needed with only a day or two float (clearing or lag time).
Maintaining a minimum of $3,000 in a combination of checking/savings accounts is what I consider “bare-bones”. But in times of emergency when I need access to a “rainy day” account, I buy time by putting all charges on a credit card. I work to build my liquidity up from $3,000 to pay off the credit card in full when it comes due.
While I’ve never had a “rainy day” so bad that I had to take further measures, my next step would be liquidating a portion of my taxable brokerage account. This account serves a dual purpose, supporting emergencies in worst-case scenarios as well as for my retirement. I have built this over time to provide ample cushion (although just recently liquidated a big chunk to fund my small business investment opportunity).
My next step after that would be opening a home equity line. The rationale of opening this rather than liquidating my IRA is to preserve the beneficial tax treatment of the IRA. Since the cash need would presumably be temporary, I’d rather take on a loan and pay the interest costs than sell IRA assets and lose their tax benefit and the opportunity cost of maintaining the assets invested.
Let me know what you think of this plan in the comments below. Am I crazy for bucking conventional wisdom? How do you plan for the inevitable “rainy day”? Do you have emergency fund alternatives?
Thanks for taking a look!
The Green Swan
Work Harder, Work Smarter, Retire Earlier and Find Your Beach
Products that may help you on your financial journey:
Personal Capital – A complete tool to monitor your personal finances
Betterment – Automated investment services and tax loss harvesting
Discover Bank – For a high-yield savings account
Motif Investing – Low cost investment accounts
Disclaimer: This post is for informational purposes only and should not be construed as a recommendation or advice. Please reference my disclosure page for more information.