The Opportunity Cost of Having an Emergency Fund
I mentioned in my last net worth update that I finally used some of our cash savings to pay down the non tax deductible mortgage balance. I’ve figured out that it’s a psychological battle with me to see my assets decrease. However, in the big picture, the money is better spent paying down debt than just sitting there earning little interest after taxes and barely keeping up with inflation.
Within the comments of the post, regular reader Telly mentioned that she doesn’t keep an emergency fund, only a line of credit if the worst happens. Out of curiosity, I asked “Since you use your LOC as an emergency fund, say you needed to replace your car. I guess you would use the LOC then pay it back as fast as possible?”
Telly came back with an analysis of why a line of credit as an emergency fund works for her as there is an opportunity cost of having cash just sitting around.
Yes, a replacement car (which is a real possibility in the near future) would be purchased with the LOC, otherwise, if I were to purchase new I’d look for a 0% financing deal.
It’s not necessarily something I recommend for everyone, but we’re in a situation where our fixed expenses are far lower than our net income so the excess cash flow would go toward paying off the LOC instead of the discretionary expenses and perhaps even the RRSP contributions.
My theory is this, for example:
$1200 / mth RRSP contributions
$0 / mth car / emergency fund
$1000 / mth RRSP contribution
$200 / mth car / emergency fund
At the end of Year 1, my car is still functioning so I have $14,400 in the RRSP in case 1 for which I received a tax refund of say $6,192 (assume marginal rate of 43%) vs $12,000 in the RRSP (tax refund of $5,160) and $2,400 in savings.
End of Year 1:
Case 1: $20,592 (14,400 + 6,192)
Case 2: $19,560 (12,000 + 5,160 + 2400)
And this isn’t even taking into consideration the compounding over the year of the extra $2,400 contributed to my retirement account in case 1 (which should in general be considerably higher than the interest earned on the $2,400 in the savings account).
Despite the fact that I’m an engineer, I’m not a math genius by any stretch (and rather lazy to boot) so using back of the envelope calculations, if my car broke down at the end of year 1 and assume that I decided to purchase a vehicle for say $14,400 and paid by LOC.
The interest rate on our non-secured LOC is currently 6% so after one year the interest paid on the loan would be <$864. This works out to be less than the difference between case 1 and case 2 results after Year 1 which seems rather cheap to me.
Feel free to poke holes in my wisdom as I wouldn’t be surprised if there were many but in the end, I feel there is a cost associated with “waiting” for an emergency like the car breaking down or the roof needing repair. I feel like our money is working for us earlier than it would be with a savings account. Again, if cash flow was tight, I might not be using this method but so far it’s worked for our situation and we have a lot of catching up to do with respect to our RRSPs.
While this strategy isn’t for everyone, I can see the benefits for those who have high cash flow relative to their fixed expenses. For those with income that is close to expenses, I would personally recommend stashing a few dollars away every month in a separate account for the occasion that something comes up.