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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:

Case 1:
$1200 / mth RRSP contributions
$0 / mth car / emergency fund

Case 2:
$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.





17 Comments, Comment or Ping

  1. 1. kevin gibb

    I set up a LOC sometime ago as an emergency source of cash, but have not used it yet.

    My strategy is somewhat different than Frugal Trader’s recent blog. And some might consider it quite old.

    I have set up several accounts with ING and deposit funds to it for anticipated expenses (i.e. new car last fall, new furnace this year, roof repairs next year, new car in 10 years, etc). The intent is to have the cash available at the time of the purchase.

    I think that insurance companies do this with their bond holdings: to match maturities with expected liabilities.

    So, I do give up the opportunity value of putting the money in a higher return investment (stock market), but I get peace of mind, knowing the future expense will be covered.

    I guess that this was how things were done before credit cards, LOC, and consumer loans,

  2. 2. Bakeapples

    But what if the ‘emergency’ involved a loss of cash flow or all income??? Start using new offer 0% balance transfers?

  3. I am a big fan of credit as a reasonable percentage of one’s income. Despite the fact that the thing that would set us free is to have as little in fixed expenses as possible ( car payment, mortgage payment), I would consider opening a new credit card account whenever my car breaks down and pay zero interest for 6 – 12 months.
    An emergency fund is a good way to save money in case of unemployment etc. But if you have cashflow producing assets, then do you really need an emergency fund? In other words, if you own $50,000 in stocks yielding 4% annually and you have determined that you need $2000 in total in your emergency fund, then the dividend income pays for that.

  4. 4. Finance_Addict

    Your post certainly sheds some light on the benefits of using a LOC for car purchases.

    While I do agree that that there is a cost associated with having you money “waiting” for an emergency (using your example, car purchase.) To me that cost is the interest rate on the LOC balance. You do need to pay back that LOC and therefore for the time it takes to pay back that LOC you will not be making any RRSP contributions during that time. So either you save up for the car purchase and pay for the car in cash or you use a LOC and pay the interest charge while you pay it back. The difference to me is I pay ~$800 more with the LOC using your example.

    However I do agree that in today’s low interest rate environment it is not a large cost using an LOC. Personally I’d rather and do use LOC to purchase good quality high dividend paying stocks rather than a depreciating car.

  5. Interesting points there guys. I think the main thing to realize is that Telly is in the enviable circumstance where their expenses are well below their income. If I recall correctly, I believe her expenses are below 50% of their income. So if one of them were to lose work, they would be fine.

    If both of them were to lose work, they would probably draw on their retirement income as they would be in a lower tax bracket anyways.

  6. 6. Telly

    Thanks FT. Your point is exactly right. While we don’t necessarily save 50%, our fixed expenses are roughly 50% of our income (we have ~ equal incomes) and that includes the double payments we are making on our mortgage. Our situation isn’t entirely enviable – we just happen to live in an inexpensive city and bought a really inexpensive (and not so enviable ;) ) house. But those extra payments are another area we could cut back on at any time.

    Again, I’m not sure this will always work for us but I’d rather load up the RRSPs early as we actually started contributing kind of late than worry about keeping an emergency fund at this point in our lives. However, with the introduction of TFSA’s next year, we will definitely begin using that as our “car savings fund”.

  7. 7. David

    What I like about this post is it forces me to rethink my initial thoughts on the emergency fund. I still think that’s what’s best for me, but it makes you consider other thoughts. Keep up the good work FT!

  8. 8. Telly

    And interestingly enough, many of FT’s posts on emergency funds have made me rethink mine as well! MDJ is definitely a great place to encourage you to check if your “plan” is still right for you.

  9. 9. Cash Instinct

    An LOC is not a guaranteed loan…if you lose your high-paying job (Example), look out for your banker to come at you and ask questions about your situation.

    It depends what kind of emergencies we are talking about… for job loss in a couple where one earns much more than the other, I do not think a LOC is enough, but it is an opinion.

  10. 10. Sarlock

    As with all things like this, it’s entirely investor dependant. The percentage chance of having to use an emergency fund plays a strong role in what type of fund you set up. If you are fairly tight on monthly cash flow, then there are more risk factors that would force a drawdown of emergency funds (short term loss of job, major expense, etc) and this may make having an emergency fund a worthwhile decision. If, however, minor shocks to cash flow would not require one to dip in to an emergency fund, then the fund is probably dead money that isn’t earning what it should as an active investment.

    Having contingency plans in place for many emergencies helps as well, as you will know whether you be able to accomodate the expense or whether it would force you to make withdrawls from investments that are tax unkind (RRSPs-unless you are experiencing a long layoff and can withdraw with relatively little tax)

    For my situation, where the loss of one wage would not force us in to an emergency situation, a good interest rate (6%) LOC serves as our emergency fund, as any major unanticipated expenses can be borrowed against it and quickly paid off with relatively little interest. Beyond a small amount of working capital left in the bank (usually less than $500 cash) the rest is invested every month.

    There is a certain psychological component to that as well… if I had to borrow from my LOC to cover a short-term cash flow shortage, I would be driven to pay it off as soon as possible as paying the interest would drive me nuts. I may not feel the same drive to replace an emergency fund in the same time frame.

  11. 11. MS

    I enjoyed this post – it made me rethink my use of an emergency fund. Here are my thoughts: First, an emergency fund is for just that, emergencies. So let’s ask ourselves, what could that be? Car breakdown? Emergency house repair? Bail? I think in all these cases, the money can be taken from a line of credit.

    Actually, I currently have my “emergency funds” in ING direct – ie another financial institution “just in case.” I almost pulled it out a while ago, and to be perfectly honest the reason I have it is because my mom implored me to have “a month salary” in cash.

    Now ironically my investing portfolio is currently 45% cash… so it seems redundant!

  12. Thank you for this post. I never thought of using an emergency fund that way. It is always good to learn new tips.

  13. Telly definitely makes a convincing point for her situation. The only thing that I question is whether most people are as risk tolerant as she appears. For example, if an emergency occurred involving a significant loss of income, she would borrow on a LOC. I would guess that most people would rather use their own money than have a significant
    amount of debt, especially during an emergency. Additionally, the early withdrawal penalty + taxes for tapping the retirement accounts too soon is less than desirable too.

    Very Interesting Post

  14. 14. Kacie

    This definitely does seem to work on paper, and perhaps it works in real-life situations as well.

    Right now, my husband and I are building a six-month emergency fund. We will use it for emergency travel, car repairs, insurance deductibles, and the big one: Loss of income.

    His job is steady and “secure,” but really, anyone can lose their job at any time. I work freelance, so my income isn’t steady, either.

    It works best for us.

  15. 15. MS

    Kacie: …. 6 months of a cash emergency fund seems like a bit of overkill. I’m not saying you should spend it, but a pref, or dividend paying stock can be sold or drawn upon to get the cash you need should there be a loss of job.

  16. If he has to replace his car, why would he use his emergency fund? Why not establish another fund for major purchases such as a new car?

  17. 17. Cannon_fodder

    I can’t remember the name of Derek Foster’s book, but he mentioned the idea of using a specific stock (Corby’s) which USED to pay out a very large dividend every few years. You would invest money in the stock and use the dividends to fund a new car purchase every 5 years is what he claimed.

    If you look at borrowing to invest in dividend producing stocks to fund the lease of a vehicle, it becomes hard to understand why comingle the two objectives.

    Perhaps if you look at it this way – leasing a car doesn’t add any assets nor liabilities to your net worth, but it does have a regular cost. On the other hand, if you borrow a sizeable sum to invest in dividend producing equities, you could come up with a structure that “funds” your lease payments by taking the dividend income and tax refunds from the carrying costs. The problem is, you still have those significant interest costs to carry the loan which would likely be at least as high as the lease payments. You do have a portfolio that could build true net worth, but you could have done this anyway without factoring in the car.

    It becomes a bit of semantics – you could fool yourself into thinking that your lease payments are tax deductible this way. But, there is quite a bit of effort to make this happen.

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