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Do I Need An Emergency Fund? (Part 2) April 5, 2007

Posted by pf in Expenses and Savings.
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In my previous post “Part 1”, I had offered an alternative approach to creating an “emergency fund”. Namely, to not create a specific cash account for the purpose, but rather utilize other tools at your disposal to create a fund you can tap in an emergency.

Today, I’d like to finish this up by discussing the pros and cons of each of the alternative sources for your funds. As I mentioned previously, not all of these vehicles are created equally and depending upon both your personality and the nature of your “emergency”, you will use one or more of these tools to get you through.

Alternative #1: Revolving Credit

This is probably the most simple, straightforward source of capital you can tap in the case of an emergency. Heck, most of us use it even when we DON’T have an emergency.

Pros:
– Capacity – usually thousands of dollars available
– Accessibility – you likely already have the credit
– Flexibility – I can obtain what I need and can pay it back over a long period of time if needed
– Affordability – can often obtain credit at 0% for a full year

Cons:
– Affordability – if your emergency is sustained and you are unable to pay it back for a long period, you may find yourself owing quite a bit of interest

When you should use it: For “lesser” emergencies that are short-term and are not expected to be “catastrophic” in nature. We’re talking thousands of dollars (ex: an unexpected car repair) versus tens of thousands (ex: medical bill)

Alternative #2: Home Equity

Obviously, if you don’t have a home, this options won’t be available for you. However, although not quite as accessible as a credit card, if you’ve owned your home for a few years, you likely have some equity which can be put to use fairly readily if needed.

Pros:
– Capacity – depends on how long you’ve had your home, but can easily be thousands
– Accessibility – home equity loans / lines of credit are readily available
– Flexibility – you can choose a line of credit or a loan with variable repayment terms
– Affordability – can often write-off interest from your taxes. Depending upon the market, the actual interest rate can be favorable.

Cons:
– Flexibility – If you don’t already have a line of credit setup, it may be difficult if you’ve lost your job, etc and need to provide some proof of income, etc. Similarly, if you want a loan, you may face the same situation.
– Affordability – You aren’t likely to find many 0% home equity loans. Also, if market rates are high, it loses some of its luster.

When you should use it: I think you could tap your home equity for a variety of emergencies…especially if it’s on the larger side where you can get a fixed rate loan versus the variable rate of a credit card.

Alternative #3: Personal Loan

I don’t like this option as much as the first two, but certainly a personal loan is an option.

Pros:
– Capacity – this might or might not be a pro. It really depends on the nature of your emergency. If you lose your job, it will be difficult to get a significant loan.
– Flexibility – You can choose the terms / repayment period.

Cons:
– Accessibility – this isn’t just waiting there for you to come get it. You are going to have to apply for it.
– Affordability – Depends on the market, but personal loans are generally at a higher rate than home equity loans, etc.

When you should use it: Like I said, I’m not a fan favorite of this option as it’s potentially more costly and more difficult to access versus some of the other options. However, if faced with other limitations, it may be a viable option.

Alternative #4: 401(k) or Traditional IRA

If you have been saving for retirement, you can usually get a loan for up to 50% of what you have contributed in your 401(k). Also, if in a hardship situation, you may also do an early withdrawal in either your 401(k) or Traditional IRA.

Pros:
– Capacity – you may have significant $$ here.
– Accessibility – you don’t have to prove creditworthiness
– Flexibility – Loans are often available for up to 5 years.
– Affordability – loan rates are typically competitive and you are paying yourself back with the interest

Cons:

– Capacity – if you access these funds in a trough in the market (assuming you are invested in equities, you may have less funds available to you.
– Affordability – If you have to do an early withdrawal, you are going to be penalized HEAVILY. You want to avoid this if at all possible. Also, if you take a loan during a trough in the market, you may not be able to recapture any gains.

When you should use it: I prefer not to touch retirement savings if I don’t have to so it can continue to work for you. In a situation where you do not think you could repay any credit card debt in a timely manner (and would face high interest) or the economics of a home equity line of credit or loan seem very unfavorable, I might then consider the 401(k) loan option. As mentioned above, I would not suggest an early withdrawal, unless in dire straits.

Alternative #5: Roth IRA

If you have money here, I’m willing to bet you’re pretty good at saving since you are likely already contributing to your 401(k) as well.

Pros:
– Capacity – probably not as much $$ as in your 401(k), but could be a fair amount.
– Accessibility – Roth IRA contributions can be withdrawn tax-free (not earnings)
– Flexibility – It’s your money and you can choose not to “pay it back” if you don’t want to
– Affordability – By making a withdrawal from your Roth, you lose out on potential returns, but you will not pay any taxes, interest, etc.

Cons:

– Capacity – like the 401(k), if you access these funds in a trough in the market (assuming you are invested in equities, you may have less funds available to you.

– Affordability – Assuming your Roth is invested in equities, if you need to withdraw during a trough in the market, you may never get back those lost returns. Also, by making a withdrawal, you will have reduced your funds available for retirement

When you should use it: If you are faced with an emergency where you are uncertain when or if you may be able to “repay” the funds you took out or the economics of the other options discussed thus far do not seem appealing, taking out Roth contributions is probably a good option. In many ways, it is very similar to a cash emergency fund in that the money is readily available and there are no penalties, interest, etc. to be paid. Again, the drawback is that you’ve reduced the amount of money set aside for retirement. However, it would be just the same as it had been sitting in a cash account somewhere. For the person who still struggles with the concept of not having a “cash emergency fund”, this may provide a suitable alternative as the money can be accessed at relatively no cost…especially if you invest it in something “safer” than equities.

To summarize, these are alternative options to the typical emergency fund options that are typically proposed in various financial publications. Each one has various characteristics which may make them more or less suitable for use in an “emergency” situation. The suggestion being made is that utilization of these alternative sources so you may continue to work toward maxing out your tax-advantaged accounts may better serve your financial goals in the long run…especially if you never encounter an “emergency” (which is very possible).

Again, however, each individual needs to weigh the various options and make the choice they are most comfortable with and makes the most sense for their situation.

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1. “Emergency” Funds - An Alternative Approach - Part I « My Personal Finance Odyssey - February 7, 2008

[…] “Emergency” Funds – An Alternative Approach – Part 2 […]


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