Here are five interesting and different ways to build an emergency fund.
Our topic for today is emergency funds: Can you be conservative with emergency funds? What options can you take with such a fund? I’ve got a few thoughts to share here.
When you create an emergency fund, it is typically used for the purpose of covering unexpected needs for cash, usually sought when one is in dire straits due to some undesirable situation. I’ve been surprised to hear that people have raided their emergency fund for other uses such as an impromptu vacation, a wild shopping spree or even to use as a home’s down payment. Now this is not at all a bad thing, since if you’re able to replenish your fund fairly easily, then it shouldn’t matter how many times you end up accessing and using your cash. The emergency fund is there to ensure that you have a liquid cash source when you need it most and if you can make sure it exists for you at all times, then you’re in fine shape, regardless of how you define an “emergency”.
There are many methods and strategies that people have used to build or create some kind of emergency fund. These are some of the ones I have heard about from those around me. For the sake of variety, I include them here, though I wouldn’t personally endorse a number of them, as displayed by the recommendations I’ve given them (Thumbs Up: 
or Down: 
). Any ratings provided are simply my own, so your opinions on this may vary. These methods also assume that you’ve taken care of your more expensive debt payments, otherwise I’d advocate paying them down first before building a larger rainy day fund.
The Different Ways To Build An Emergency Fund
What can possibly serve as one’s source of cash in case of an emergency?
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#1 Using your credit card
Okay, now I flinched when a friend told me that he had no emergency fund but instead told me that “that’s what credit cards are for.” He’s a shoot from the hip kind of guy who is very comfortable with taking risks, so I could understand his stance on this. In fact, he’s put all his savings into the stock market and doesn’t have pure liquid cash accounts. He claims that in an emergency, he would first use his credit card, followed by his brokerage account, to address his cash requirements.
Sounds like there are people who prefer to rely on plastic for their emergencies, regardless of whether they can afford to build up their savings. Well, if you’re going to use credit cards for your emergency, make sure that the card you have has a low interest rate and good features. Some people are happy with “the credit card” approach; while others have no choice but to go this route. In this case, your fund is only as high as your credit limit and the number of cards you own.
#2 Using your retirement account or a home equity line of credit
So you already own some assets such as a 401K or a nice home. I’ve never really thought of these as cash sources due to their illiquid nature, but it hasn’t stopped some folks from borrowing against them. Given how we can use practically anything now to squeeze out much needed cash, it’s not uncommon to sacrifice a bit of the future to take care of an immediate problem. But be very careful as there is a cost to doing this, whether it be in fees, potential penalties, extra tax, or the additional risk you’re taking on when using your assets as collateral. I’d like to delve into details regarding this, but it will be the subject of an entirely different post.
#3 Using a standalone cash account separate from your investment portfolio: the traditional Emergency Fund
Isolating your emergency fund from all other savings and investments is the traditional way of building an emergency fund. The methodology here is to compartmentalize money based on the various goals you’ve designated for your funds. After taking care of bills and other immediate payments, set some money aside in a savings account or money market fund equivalent to 6 months to a year’s worth of expenses. Any more cash you are able to build up beyond this point can go into your investment portfolio. Any time you’ve used up some portion of your emergency fund, work on replacing the lost funds as soon as you can. This works as your primary insurance against impromptu money requirements. In the meantime, you can decide to divert the rest of your money to a fully invested portfolio according to your asset allocations.
Understandably, not everyone has the spare money to start a portfolio beyond an emergency savings fund — in this case, do what you are comfortable with, especially if you can withstand more risk. On the other hand, there are those who eventually end up maintaining an additional “cash” position beyond their emergency fund and as part of their investment portfolio; this would mean having redundant cash reserves lying around. You’d have an emergency fund in a savings account while perhaps simultaneously maintaining a cash position in a brokerage sweep account as well, as part of your asset allocation. Either way, it’s up to you to hold on to redundant cash accounts just as long as you’re aware of this situation and you’ve intended it to be part of your overall financial plan.
#4 Using the cash or liquid position of your portfolio: the Emergency Fund is part of your asset allocation
Alternatively, there is a simpler approach to handling money. I personally subscribe to this approach, which is to combine all my cash with the rest of my investment portfolio and use the “age” formula, which is a popular rule of thumb amongst financial planners. Subtract your age from 100 to get some idea of how much stock you should be owning at this time. For example, a 30 year old is expected to own a portfolio consisting of 70% stock (100 minus 30) and 30% cash and bonds. You may want to adjust the result according to other factors such as your risk tolerance and financial goals. This would be ideal if you have a large portfolio that already contains a cash cushion expected to run higher than the 6 months to 1 year budget that the traditional emergency fund sets. This may be less favorable if you have more modest savings that run less than your projected half year’s worth of expenses.
#5 Using the Emergency Fund also as an “opportunities” fund
I have buddies who have what I would call an “opportunities” fund. Like shrewd vultures, they are waiting in the wings for that opportunity when their investment market of choice drops considerably in order for them to pick up the spoils. There’s a friend of mine who is known for his conservative approach to investing but he’s also a highly astute businessman. He has a large cash holding that is just sitting around waiting to be used for possible real estate transations in the future or as angel funding for small businesses. I can bet that he won’t need an emergency fund based on the size of this liquid position that he has. If he’s ever in an emergency, he’ll be drawing off of that fund.
I am sure there are many more ways and methods out there that have been employed for building and maintaining that all important emergency fund. The ways are as diverse as we all are, especially given the resourcefulness and creativity displayed when we’re cash strapped. Now I have to do a little tweaking here myself as just a couple of weeks ago, I had to raid my short term cash fund. Well you can guess why — here’s a genuine emergency for you: I had to fork out some money to pay the IRS!
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{ 14 comments… read them below or add one }
If you carry a debt load, I’d be interested in taking Dave Ramsey’s advice as well. I’m all for paying down “bad” debt as quickly as possible, then building a solid emergency fund. If such debt exists for you, a smaller emergency fund IS a more comfortable approach while you work on getting rid of the debt.
Note the caveat I’ve included. 🙂
Your friend in #1 is my hero.
Broke Now Rich later, LOL. Yes, my friend is an amazing individual alright. And I mean it in an admiring way. He definitely has his own financial strategies which make my hair stand on end but somehow, it’s worked very well for him. Let me tell you about him one day… he’s got nerves of steel.
i would disagree with the credit card option only if you do not have a 12-15 month 0% and have the ability to pay them off, say you did the arbitrage thing and locked up the money in t-bills or rolling cd’s. 0% allows to tied you over until these vehicles mature. there are risks involved and of course you won’t always have a 0% card. however, it is an option if you have planned it that way.
Another option for an emergency fund might be to use the principal portion of your Roth since this can be withdrawn without penalty. Becuase of this I would think one would be better off funding a Roth to the max before adding to an emergency fund. It is after all only for an emergency (hope you never have to use it).
Interesting. What about the concept of having a cash emergency fund that is accessible even if the lights go out for awhile? How much do you suggest then? And what is the best way to store it? I have heard of having it in a ziplock bag in the freezer as it is fire retardant. Of course a fire safe would probably be best. But for an average family of four, how much to keep in cash on hand vs. invested is what I wonder….
Well I try keep at least 1000€ in cash (I’m European) and 5 Troy oz of gold coins in case something really bad happens and paper money is not worth worth more than what it really is –paper.
What if you pay down your mortgage by the amount you would otherwise put in your emergency fund? You’d save the interest on your mortgage (I’m in Canada and mortgage interest is not deductible.) If you put a line of credit in place, you could always pull the money back out at the rate that your mortgage would be. You’re simply storing the cash in your home equity — note that I’m saying you should add this equity, not simply take it from what is there. The interest you “save” is tax-free. And your mortgage payments are a bit lower, giving you the opportunity to put more money into savings.
Just in case I wasn’t clear, I want to emphasize that I mean paying down your mortgage by an extra $10k or $20k, not that you are pulling money out of the equity you earned by making payments or through appreciation.
Personally, I use the ingdirect savings. It earns 4.5 percent and can easily be linked to your bank account. My income varies so I manually enter 15% of my income, but you can set it up for automatic withdrawl.
Good News: I have 4050.35 in my emergency/prudent reserve. It feels good.
Be sure to visit http://www.debtingthomas.com
Peace
Chad
The margin account at my broker is my emergency fund. The trick is to have margin available but not use it unless it is an emergency. That way my money keeps working and if I ever need cash, I do not need to sell assets to get it.
It is pretty liquid too if you have checkwriting privileges or direct transfer from your broker to your bank
I also put money into ingdirect.com and sogoinvest.com
I personally use the credit card method. It’s actually the only time I ever use the cards I do have.
I have medical bills and OD bank accounts from my spouse and after I file my taxes which is going to be around 6 thousand I’m going to pay off all credit cards and put the rest in a separate place and save it. Example: If i have $3,000 left for savings and i want it to last me till next years income tax then i divide the $3,000 by 12 and it gives me 250.00$. and i can use that as a little extra money each month if I’m short on cash. And if i don’t need it then i just save it. ITS IMPORTANT NOT TO LIVE PAYCHECK TO PAYCHECK WHEN YOU HAVE CHILDREN. and I think this method helps 🙂
Using your credit card for emergencies? Bah, that’s pretty common, actually. Recently, I was talking with my BIL and we were discussing the issue of emergency funds so I asked him how large a fund he had. I expected a straight up answer from him of “oh, around a few month’s worth of expenses.” He made good money after all. This guy, with a good-sized family (a wife and 3 kids), surprised me with his response. He basically said his trusty credit cards will save the day.