Emergency Funds in FI
What if everything you thought you knew about emergency funds was wrong? What if there was a different way to approach your emergency fund in FI that would still let you keep money for emergencies, but would also make you more money?
For years and years, financial experts have drilled into us that we should have money stashed away to deal with emergencies. That hasn’t changed.
What has started to change, especially for people pursuing Financial Independence, is where we keep that money. Typically, you would keep the money in a bank savings account or a money market account where it earns very little interest but is easily accessible in the event of an emergency.
The new way of thinking about emergency funds in FI says to change where you keep that money. It calls for you to put it someplace less accessible so that it would earn more while you were waiting to potentially use it. It makes your money keep working for you.
[highlight]In this article, we’ll closely examine this non-traditional approach to emergency funds in FI and compare it to the traditional one. The success of this idea depends on what a true emergency is, and we’ll define one. We’ll also discuss HELOCs and credit card floating, two new strategies for handling a crisis. Finally, how to tell if the nontraditional emergency fund is right for you and the action steps to take if it is.[/highlight]
Table of Contents
- Traditional Recommendations For Emergency Funds
- Non-Traditional Recommendations For Emergency Funds
- What Do True Emergencies Cost Upfront
- What Is An Opportunity Cost And Why Does It Matter
- Non-Traditional Ways To Fund An Emergency
- How To Tell If This Method Is Right For You
- Action Steps To Move Your Money To A Non-Traditional Emergency Fund
Traditional Recommendations For Emergency Funds
Emergency funds aren’t a new concept. You know the drill: Part of being responsible with your money is keeping a certain amount in an easily accessible place in case of an emergency.
Depending on which expert you listen to, that amount is anywhere from three to 12 months of expenses. The general recommendation is to keep those funds in either a bank account or a money market account.
Why? Having that money close at hand means you can afford to cover any crisis that comes your way. That could be losing a job, covering a medical emergency, handling a home repair or car repair emergency, or anything else that happens.
That’s the traditional way of thinking. Now let’s examine the non-traditional way to think about emergency funds for those on the FI journey.
Non-Traditional Recommendations For Emergency Funds
Let’s make one thing crystal clear upfront. Rethinking your emergency fund in FI doesn’t mean you choose not to have any money earmarked for an emergency. It’s really about how immediately accessible that money is.
In ChooseFI Podcast 66, Jonathan and Brad interviewed Big ERN (Early Retirement Now). He proceeded to do two things that rocked Brad and Jonathan’s world.
First, like a savings superhero, he revealed his true identity. He told more of his life story and talked about how he was poised to give notice or his impending departure at his job so he could retire early. That meant he was free to reveal himself.
Secondly, he offered this entirely new way of thinking about emergency funds. The question that prompted his new path is this: What emergency is there that you would need to have your emergency fund immediately accessible?
The answer is, not many. What that means is that you could be storing your emergency fund in something that gives you a better interest rate for a higher return because it’s not money that you have to be able to get to at a moment’s notice.
When the emergency is actually happening, you can use your credit card to float the money until you can receive the funds stored in that better place. Anything that might cost more than that could wait to be paid for until a later date after you have received your funds.
What Do True Emergencies Actually Cost Upfront
The success of this plan rests on what emergencies actually cost. When Big ERN posed the question about what emergencies actually exist that would require having a large sum of money available immediately, it proved to be a difficult question to answer.
Try as they might, Brad and Jonathan couldn’t come up with something that costs more than $1,000, which most FIers have in their bank account. Emergencies related to your health, home repair, car repair, your pet, losing your job – none of them amounted to much more than $1,000 upfront.
Many of the things on that list likely cost much more than $1,000 in total. But the entire bill is never due immediately. There’s always at least a few weeks in between when the emergency happens and when the total bill is due.
Even the most pressing emergency, like losing your job, shouldn’t cost more immediately than what you have in the bank right now. And by the time you’ll need to use money from your emergency fund, it will have been transferred to your account.
So if you don’t need a lot of money upfront, why are you keeping it in a bank account or a money market account where the interest rate is next to nothing? You could have that money in a number of other places – equities, index funds, even stocks – that will help your money grow while it sits. This is where FIers can think outside of the box and get creative with their emergency funds.Â
What Is Opportunity Cost And Why Does It Matter
What started this whole change of thought regarding emergency funds in FI is the concept of opportunity cost.
Opportunity cost is asking yourself what you’re giving up in order to keep something else the way that it is. In this case, what are you sacrificing in order to keep your traditional emergency fund?
The answer could be a substantial amount of wealth. On his blog, Big ERN cites a whitepaper on Personal Capital’s website that succinctly explains the math behind this opportunity cost. In summary, it states that you’re losing about a third of your retirement spending by leaving all of your emergency cash sitting in the bank.
As an example, it cites the fact that if you had invested $1 in a 70% stock/30% bond portfolio in 1983, by 2013 that $1 would have been worth $18.36. On the contrary, if you put $1 in a 60% stock/20% bond/20% cash portfolio at the same time, it would have been worth only $14.11 in the same time period.
You could have made 33% more money in that same time period with a different outlook on emergency funds. Over the course of your lifetime, you can see how that would add up tremendously.
So the opportunity that keeping cash on hand costs you when it comes to your retirement savings is significant. At best it means a large cut in your retirement spending. At worst, it means that it takes you more years before you can retire with the amount of money you know you need.
Non-Traditional Ways To Fund An Emergency
In the same podcast where he introduced the idea of a non-traditional emergency fund to Brad and Jonathan, Big ERN discussed other places to find money that could help you pay for any emergencies.
There were two main sources of extra funds that he named: HELOCs and your credit cards. It's possible one of these could be your emergency fund in FI. Let’s look at both.
HELOC
A HELOC is a Home Equity Line Of Credit. You usually have to have at least 20% equity in your home prior to qualifying for one. The bank sets your HELOC credit limit based on the amount of equity that you have.
How does a HELOC work?
Once your HELOC is open, you have a draw period where you can remove funds from the line of credit. The draw period usually lasts five to ten years. A repayment period follows where you have to pay back what you borrowed with interest. You cannot take any more money out during this time, only pay it back. This period usually lasts from ten to twenty years.
What makes a HELOC attractive is that the interest rates are usually much lower than that of your average credit card. The average HELOC rate currently starts at 2.99% and goes up to about 21%, based on the borrower. Banks examine your debt-to-income ratio, the amount of equity that you have in your home, current interest rates, and your credit score in order to determine your rate.
Things to consider
There are two things to consider when applying for a HELOC.
- You usually use your home as collateral. That means if you don’t repay the HELOC in the right time frame, you risk going into foreclosure.
- The variable interest rates of a HELOC could come back to bite you. While they’re mostly based on you and your financial situation, they’re also dependent on national interest rates. If those go up, you could end up paying more to repay the money from the HELOC.
Knowing all of this, if you have a HELOC at the time of your emergency (or you’ve done the work to know where to get one), you'll have extra funds close at hand whenever you need them.
Credit Cards
If you’ve been around FI for any length of time, you know how to use credit cards wisely. You don’t want to carry any debt with them, but you do want to use them for your purchases so that you can earn points and rewards with them. The goal is to then immediately pay off the entire card.
Credit cards can work to help you float money during an emergency while you work to transfer funds to your bank account.
Things to consider
There are a couple of things you need to consider before you make this choice.
- Credit card interest rates can be crazy high. As of the publication of this article, they average 14.58%/month for existing customers and 17.98%/month for new customers. That’s a lot of extra money to pay back if you can’t pay off the whole thing on the first bill.
- You need to know your credit limits. Obviously different cards have different rates and different credit limits. In order to know how to best pay for an emergency, you should plan out scenarios for how to do that take both of those things into account.
How To Tell If This Method Is Right For You
We’ll tell you now that this strategy might not be right for everyone. In order to know if it’s right for you, see if you can answer “true” to the following statements.
You have a very solid financial foundation.
Big ERN, Jonathan, and Brad are educated risk-takers. They have a significant amount of wealth in the bank. They’re not just jumping into the latest financial fads, and they wouldn’t recommend that you do that either.
The key to the success of this non-traditional plan for emergency funds in FI is the financial foundation that you have in place. Big ERN lists some hallmarks of a good financial foundation in his blog post about emergency funds.Â
- No consumer debt
- A net worth in the seven figures range
- Structured monthly expenses
- Knowledge of the financial tools available to him if he needs them
- A plan for what to do should a crisis hit
If you are still struggling to pay off debt and haven’t started saving much of anything yet, this is not right for you where you are right now. This step is really for FIers that have moved into a more advanced way of approaching their finances.
You have done your research about different ways to float larger amounts of money.
As we mentioned above, two of the most popular places to access larger amounts of cash than what you might have on hand are through a HELOC and using your credit cards.
However, the time to start researching a HELOC is not when you’re in the middle of a crisis. You should have that plan in place before the crisis hits. In other words, know who has the best rate on a HELOC so you know right where you’re going to get one if you need it and don't already have it.
Which credit card will you use to float the money until you can transfer the funds to pay for the emergency? Which card offers the most points or rewards? What are the limits on each card you have? You likely won’t have the time or energy to research this when catastrophe hits, so do it before disaster strikes.
You are comfortable choosing flexibility over fear.
In Podcast 66R, Brad openly admits that he has a large amount of money in his bank account. He stated that he feels comfortable with the idea that he has that money very accessible should he need it.
In choosing the non-traditional emergency fund in FI route, you’re choosing to open your mind to other possibilities. How much more money could you be making? Could you retire even earlier if you didn’t have this cash drag on your portfolio?
The bottom line is that people who choose to follow Big ERN’s advice on this are ready to let go of their fear of not having money directly on hand. They’re ready to be flexible enough to envision their money in a different way.
Action Steps To Move Your Money To A Non-Traditional Emergency Fund
Moving your money from your bank account or money market to an investment with a higher return may not be hard, but it still requires some planning. Start by asking yourself these three questions.
Where are you going to put the money?
You will need to be careful where you put it as you still need access to it without penalties. Putting money in your 401(K) or a CD ladder and then having to withdraw it may cost you a large penalty. Look for options that have low-to-no penalties for withdrawing your money.
How – or will – you diversify?
Part of moving your money should include an examination of your current investments. What do you have that’s working? Do you want to contribute more to that or branch out into other areas?
In a follow-up podcast to Big ERN’s new theory on emergency funds, Brad discussed the idea of putting his emergency fund cash into a Vanguard taxable account with automatic investments. If he does that, he doesn’t even have to think about making decisions regarding the money. Vanguard will do it for him.
Are there other ways to use that cash accumulation that make more sense?
In the same podcast, Brad also mentioned that because he already has significant funds in other places that are easily accessible, he might want to think outside the box.
He could use the money to pay down his mortgage. Or he might use it as a down payment on a rental property investment.
The idea with these action steps is that there isn’t one right way to use the money. You need to take a close look at what you have and what your goals are so that you can make the decision that makes the most sense for you.
Final Thoughts
While this isn’t a step for people just starting to understand their money, examining your emergency fund in FI is definitely something anyone pursuing Financial Independence should keep in the back of their mind as their financial well-being becomes more secure through years of saving and investing.
The bottom line is that you need to know your finances and your goals. When you do, the decision about what to do with your emergency fund in FI will become clear.Â
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