Wednesday, November 01, 2006

Rethinking emergency funds

How much emergency cash is really needed?
Can non-cash investments be liquidated to provide short term cash if needed?

Here are some interesting questions to consider:
  • What would the tax consequences be, if any?
  • How long would it take to have access to the liquidation proceeds?
  • Do you have enough cash or credit on hand to wait until the liquidation proceeds are availalbe?
  • If you could identify which assets would be liquidated, would you have enough given their expected level of volatility; i.e. some asset classes can lose as little as 7% in a given period while others can lose as much as 44%. If you lost 44%, would you still have enough assets to sell?

Once assets are sold would you rebalance your other assets immediately or wait until the emergency funds are paid back?

If you had an emergency and relied on credit, would you need the funds as cash - if so how would you convert the credit to cash?

If you don't have a line of credit - what would be an alternative?

Would investment returns exceed the higher interest rates from a

With these thoughts in mind, a few interesting things appear:

  1. It may make sense to maintain a home equity line of credit (LOC) for emergencies - assuming you can put off dipping into it for convenience / non-emergencies.
  2. With an LOC, you can reduce your cash reserves and put them in more profitable long term investments
  3. A spending plan should be in place to differentiate cash accrued for short-term expenditures (this year) versus actual emergencies (job loss, etc...)
  4. An emergency cash plan should be put in place. It should show how much cash could be made available within 1..14 days. Each day showing the source and the actions needed to get it.
  5. The emergency cash plan should be reviewed and updated when investments change, lines of credits change and annually to review utilization of emergency funds - you need to audit the usage to determine if you're really using the funds for emergency purposes.

I admit, this approach is fairly bold. I'm going to sell my house before mid-2007 so opening a new LOC may not work for me.

What other sources of credit do I have? Credit cards - but how do I turn that into cash? Margin accounts on investments - might be a convenient way to go - will have to see what happens after we relocate investments.




Lazy Man and Money said...

People laugh at me, but my HELOC is my emergency fund. I just don't want to have $25,000+ tied up making 5% in an internet bank. I'd rather have it making 8-12% in the stock market. I can't imagine over the long haul, that I'd have that many emergencies - at least I'd be REALLY unlucky if I did. I'd gladly take an 8% hit on that money for that 5% of the time, in order to have bigger gains for the rest of the 95%.

2million said...

Good stuff.
I agree on the HELOC - I consider that my emergency fund after my available cash runs out.

I never thought about putting together a spending plan or an emergency cash plan - these make a lot of sense.

I move monthly monthly to savings accounts but its hard for me to differiate between money I am putting away for emergencies and money for my new home purchase or something. I should find a better way to do this.

Foobarista said...

I'm in tech, in a notoriously volatile area that sometimes has years of downtime, so I have a big long-term efund in I-bonds. They aren't great, but they are currently getting about 6.5% interest, are exempt from state tax - making their effective yield over 7% for us - and are "zero-coupon" so you don't pay taxes until you sell them. I have enough money in these bonds to last about 18 months at our current household burn rate.

I have a shorter-term efund with about 2 weeks of expenses in a credit union savings account earning 5%.

My own "debt paranoia" prevents me from using debt as an efund - I'd hate the feeling of drifting deeper and deeper into debt while being unemployed.

makingourway said...

Thanks for the wonderful comments.
These are my thoughts:

1. Lazyman - I think you're doing the right thing with the heloc - it allows you to maximize long term return - provided you have enough assets that could be liquidated to cover the long term debt (incorporating discounts for volatility).

2. $2m - we're in the same camp re Lazyman and HELOC.
I recommend using putting housing savings in a stable value account (MM) unless you have a very long time to save. You might try using quicken's savings goals to accrue savings money for specific purposes:

Here are the instructions:

"Choose Planning menu > Savings Goals to open the Savings Goal Planner.
Click New on the button bar.
Enter a name, amount, and finishing date (date by which you want all money set aside for your goal) for the savings goal. The name you enter will be the name of the account used to track the savings goal."

I recommend playing it very careful with savings goals...too many are unmanagable.

An alternative is to enter a future dated transaction to remove the money and put the category as the spending source.

3. Foobarista - I think you're doing something very similar to what we've been discussing. You're putting your emergency money into a higher return investment - albeit a stable value one - the ibonds.
Your concern re: digging yourself into debt is something more psychological than economic. In my model, you would only establish enough HELOC such that it could be offset by asset sales (with available assets adjusted for volatility). As long as you knew you would sell an asset to cover the emergency cost, you would be at net zero - if an emergency occurred.

I think there are enough ideas here to start creating a planning template.


YeOleImposter said...

Two questions come to mind...

1. Say you loose your job - now I need a month's salary. Do I pull $$ out of the HELOC each month? Will be kind of strange to use the HELOC to pay the mortgage.

2. Rather than 3-6 months salary in a MM account for a 'major' emergency, I can use the equity in my home. How much then should be a 'minor' emergency fund?

I really like the discussion. I was trying to ask a similar question over at Dogberry's Personal Finacial Management Plan - Help Wanted.

Money & Investing Dogberry Patch

Foobarista said...

Yes, it's a bit "uneconomic", but having been unemployed before after the dotbomb, the last thing I need is the painful feeling of sinking deeper and deeper into debt while wondering if I'll ever find a job, or have the no-pay "job" I may get at a new startup funded.

Few people are true examples of homo economicus. Those that manage to pull off that feat, I'll admit, tend to end up rich.

Anonymous said...

I think the "emergency fund" concept is really a wake up call for those who have no assets in "taxable accounts". If you don't then your only way of getting cash for an emergency is going into debt against housing equity (if you have it), withdrawing from retirement accounts (if you can) or borrowing on credit cards. For those who have taxable accounts that are pretty large relative to annual expenses, borrowing in an emergency doesn't sound so scary and usually there is some investment that can be sold off to start with - possibly a poor performer...