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Why You May Not Need An Emergency Fund

Emergency_by_Tax_CreditsEmergency funds are almost always highly recommended by personal finance gurus and advocates of all types as one of the first financial priorities for any person no matter their financial situation. The rule of thumb is that you should have 6 months of your salary saved up as cash in an easy to access account to bail you out of any large unforeseen expenses, if you happen to lose your job, or if you become ill. Many even recommend building one before paying down potentially high interest debt.

Having an emergency fund is all well and good, but it is a terrible use of money because for it to qualify as an emergency fund the money usually has to sit in bank account somewhere earning negligible interest that is taxable. Putting that money to use paying down debt, like your mortgage, or investing it will get you much further ahead.

But What If An Emergency Comes Along?

Of course, if a real emergency comes along, you do want to be prepared and have some money available to deal with it. Fortunately, for a middle class person or family there are lots of way to access cash in a pinch if you really need it.

Alternatives To An Emergency Fund

Any one of the things I am about to suggest on its own would not be enough to replace an emergency fund because they aren’t fool proof like cash in a bank account. However, my hypothesis is that combining a bunch of these backup plans together can essentially replace an emergency fund if you’re willing to accept a small amount of extra risk.

By the way, cash in a bank account isn’t actually fool proof either … but that’s a subject for another article on another day.

Related: Plan Ahead: My Best Financial Tip!

Home Equity Line Of Credit (HELOC)

A home equity line of credit is an extremely low interest loan that is tied to the equity you have in your house. The amount you can borrow from the bank using this line of credit increases as you pay off your mortgage in a predictable way. You can then access those funds at any time for a very reasonable rate.

For instance, while we owned our first house, we had a HELOC with Royal Bank that had a 3% interest rate for almost the entire duration of the mortgage until we sold the house. As we paid down the mortgage, 80% of the equity we had in the house was available to borrow again through the line of credit. So if we had $50,000 paid off to date, we could borrow up to $40,000 at any time at the 3% annual rate.

The interest rate is always variable and is tied to the prime rate. For us it was exactly the prime rate which held at 3% for a long time. As interest rates rise, this rate would also rise but it is still guaranteed to be some of the cheapest money you can get your hands on.

Unsecured Line Of Credit

An unsecured line of credit is very similar to a HELOC except that there is no collateral to back it up like your house that the bank can repossess if you don’t pay your monthly payments. The interest rate for these loans depends highly on your credit rating but it is still likely to be relatively inexpensive when compared to something like credit card interest rates.

Low Interest Cash Advance

There are many credit cards out there that will give you a low interest cash advance for anywhere from 6 months to a year or more. Interest rates can be as low as 0% + a small cash advance fee which is usually 1% tacked on to whatever amount you choose to borrow.

It’s important to note that cash advances don’t always come with low interest rates and if you do get one, it’s a good idea to ONLY use that credit card for the cash advance otherwise your low interest loan might accidentally get paid off when you think you’re making your payments towards your regular purchases.

To secure a low interest rate, you want to apply for a card that has a promotional low interest rate or call the issuers of the existing credit cards you have and request a low interest cash advance loan. Most credit card companies will have something available for you as they usually send you cheques every month or two advertising a low interest cash advance rate.

Be sure to set a calendar reminder to pay off your low interest loan before the interest rate skyrockets to 20% or more after the promotional interest rate ends. By that time hopefully your emergency has subsided and you’ve been able to pay back the loan, but if not you can use one of the other options to pay it off or take a second low interest cash advance loan and use it to pay off the first.

Related: The Best Credit Cards In Canada

Skip Payments On Your Mortgage

Many banks will let you skip one or two payments on your mortgage without penalty and for any reason as long as you notify them of the skipped payments. Be sure to take full advantage of this if you have a minor emergency and are really strapped for cash.

Instead of building an emergency fund, hopefully you’ve been using those funds to pay down your mortgage or make some other investment. If so, you will also find that many mortgage lenders will let you skip as many additional payments as you want without penalty as long as you are ahead of schedule on your mortgage. That means as long as you have given the bank more money than you are obligated to at that point in time, you can stop paying altogether until that is no longer the case.

Imagine a scenario where you’ve doubled up your monthly payments, increased your payments every year by 10 or 20 percent, and/or made significant lump sum payments towards your mortgage. This can quickly put your far ahead of the standard payment schedule and you may be eligible to not pay your mortgage for a period of many years. Check with your individual lender for their terms, but I know with my RBC mortgage that this was an option for me.

Liquidate Your Investments, RRSPs, and TFSAs

If paying extra on your mortgage isn’t your cup of tea, hopefully you’ve been putting your extra emergency fund alternative money into investments of some kind. Most middle class Canadians have RRSPs and now TFSAs.

Taking money out of these retirement accounts is often considered taboo and there is even a big myth that you will be heavily penalized for doing so. In reality, unless the account is locked in, which most aren’t, then there is no penalty for making withdrawals other than paying taxes on the money in the case of RRSPs, which you are eventually going to have to pay anyway.

You obviously don’t want to sell investments at the wrong time, but if a real emergency happens and you have no other choice, you can at least cherry pick those investments that have done well and sell those first. That way you are selling high and giving your other investments a chance to catch up. A TFSA account would be the first choice because there are no tax implications or complications and you can redeposit the money back in to the account the following year without penalty as your contribution room is never lost with a TFSA.

If you only have RRSPs, you don’t need to worry that much. One of the main reasons for an emergency fund is loss of employment. If this is the case, your income will be lower for the current year anyway, so withdrawing RRSP money in that year isn’t so bad because you probably won’t be in the highest tax bracket anyway. Like I said, you’re going to have to pay taxes on your RRSP money eventually anyway so you might as well withdraw it on a low income year if you’ve lost your job.

Unfortunately, once you withdraw from an RRSP you can never get that contribution room back unlike with TFSAs, so that is one thing to be aware of. Although, most Canadians are nowhere near close to maxing out their RRSPs anyway, especially now that we have TFSAs, so it isn’t really a major concern.

Use Your Credit Card To Buy Time

Some of the above options may take some time to pull off, so you definitely want to take advantage of the grace period your credit card gives you to give you some quick cash while you decide which option is best for you. You can simply charge whatever expense you have to your credit card and take advantage of the free money until the next payment date which will usually be at least 30 days from the date you make the purchase.

I would never recommend carrying a balance on your credit card because the interest rates are extremely high and you could get caught in a debt spiral, so make sure you have a plan for paying off your credit card before that happens.

Sell Your Stuff

If you are a typical Canadian, you have a lot of things lying around your house that you don’t really need but that have some value. Now is the time to sort through all that stuff and pick a few high value items that you don’t really need and post them on Kijiji, Craigslist, Ebay, or have a yard sale.

Risks To Be Aware Of

There is slightly more risk with this approach than having a true blue emergency fund, but it is minimal. If you are smart with the money you would have been using for your emergency fund you should have even more money available to you than you would have if you had kept it stagnating in a low interest savings account.

Instead, your money has been working for you and the debt savings or investment growth are hopefully substantial and you can use that to your advantage in an emergency situation! Here are a few things to be aware of.

Your Loans Could Be Called At Any Time

Almost all loans given to you by a financial institution can be called at any time because the money is technically their money, not yours, and they have the right to ask for it back when they need it. The chances of them calling a loan early are slim to none because loans are how they make money and they would immediately lose the trust of their customers if they started calling a bunch of loans.

That said, if your credit rating were to become very poor and they become aware of it they might be inclined to call a loan to avoid the risk of default. Also, if your lender were about to go bankrupt they might also call a loan just to keep their business afloat. However, if the loan is backed by your house, you always at least have the option of giving them your house in the worst case scenario.

Your Credit Score Could Fall Rapidly

If you start maxing out your credit lines, taking out cash advances on your credit cards that use up most of your limit, and it becomes known that you’ve lost all of your income, it is definitely possible for your credit score to fall rapidly. This will affect your ability to get any new loans and good interest rates on financial products.

This is why it is a good idea to take out credit lines and credit cards before you actually need the money so you won’t be denied in your time of need. It’s still a risk to be aware of though.

Your Investments Could Tank

If you decided to use your emergency fund money to invest in risky stocks or we have a global financial crisis like in the 2000s, your investments could have lost a ton of money. This make selling them at the time of an emergency a very bad idea.

My preference would be to use your emergency funds to pay off your mortgage so at least you will have a HELOC to fall back on if necessary. If not, hopefully you have at least one safer investment that has avoided steep declines that you can use in the short term.

The Doomsday Scenario

Some of the risks I mentioned above are not likely to happen. If, all of a sudden, all of your loans are being called, your investments have gone nearly to 0, and you have no other means of accessing emergency money, then we all have bigger problems to worry about. That probably means that the Canadian or world economy has failed and your money is now worthless anyway.

For that reason, I tend to view the above options as good enough for an emergency fund in 99% of the cases that could crop up. The other 1% or less just isn’t worth planning for in my opinion. You take a bigger risk driving to work every day or eating the spoiled food in your refrigerator.

Keep in mind, I'm not a financial advisor and you should consult a professional before making any big financial decisions.

Do You Have An Emergency Fund?

If so, would you consider getting rid of it by using alternate means to access funds in an emergency?

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Mark Ross's picture

I think one should really have his or her own emergency fund than getting money from another place or person and be asked to pay for interests. You can still build it up little by little, so you shouldn't worry about not able to build up one yourself.

Stephen Weyman's picture

Yes, some people will always think that way for sure. But if you have tons of money available to you anyway I don't think it always makes sense to have a large amount in a low interest account just sitting there?

Do you have any specific reasons for thinking this way?

Mark Ross's picture

Well,I just want to feel secured, and having some money in the bank or in a low risk investment account makes me feel that way.

My Own Advisor's picture

I don't agree Stephen. I think unless you have no assets, most adults should have an emergency fund. Even a small one (say $500).

If you don't, you are essentially paying your way out of debt when crap hits the fan.

Isn't that what everyone is trying to do, get out of debt? :)

Seems counter-productive, maybe just me?

Good details though.
Cheers,
Mark

Stephen Weyman's picture

Yes, that seems to be the predominate thinking. My view is what is the point of having assets if you can't leverage them or tap into them during an emergency?

To me, the definition of an emergency is something that happens rarely or is catastrophic so it isn't like you are borrowing money or selling investments on a regular basis. And, by making your money work for you, you should have more of it in the form of assets to take advantage of.

For instance, instead of having a $100,000 mortgage, you only have a $50,000 mortgage because you used your emergency funds to prepay your mortgage (which is just another type of debt anyway). You can then re-borrow that $50,000 when emergency strikes at an interest rate that was close to your mortgage interest rate anyway and be in the same exact position as before except you've been saving on mortgage interest all the years before the emergency happened so you are much further ahead.

You mentioned $500. Of course, you should have a bit of a slush fund so you're not always going overdraft on your chequing account the minute you have a bill that is slightly higher than normal. But I'm talking about a real emergency fund here, not a few hundred dollars.

soal's picture

I think this is a pretty solid idea with maybe setting up a few thousand in a TFSA savings account to take some of the month to month uncertainty out of the equation.

Always use your credit card with the most points/cash back and always pay off the whole balance no matter what even if its with a line of credit. This will give you a 30 day interest free loan every month that can help and the rewards don't hurt.

Stephen Weyman's picture

My sentiments exactly soal. Take advantage of the vehicles you have and maximize the value you get out of them as much as possible.

You just have to be disciplined when doing so.

Saver Gal's picture

I believe that everyone should have an emergency fund of at least 3 to 6 months of living expenses for the following reasons:

1. Liquidity and timing - Money that is readily available can be accessed anytime, regardless of market conditions. It should be in a low risk, fee free investment (and there is nothing wrong with a high interest savings account for this purpose).

2. Psychological benefit - Life can throw us some pretty nasty curves from time to time. There is an enormous benefit in knowing that if one loses their job that they can weather a period of time. It reduces the financial stress of difficult life events. It's comforting to know that when the "last thing you need to happen" financially has an immediate remedy that does not disrupt or increase your other financial obligations.

3. Promotes good financial habits - People should be encouraged to budget for savings targets for a variety of purposes such as retirement, education, major purchases AND emergencies. Each of these areas may have different timelines and risk objectives. These savings should be segregated from one another to allow for the appropriate investment vehicle for each savings target. No one solution is appropriate for all savings targets.

4. Opportunity Value - Sometimes an opportunity pops up that one would like to take advantage of...a great deal on a trip of a lifetime, a piece of property that would be a good addition to one's real estate holdings, an undervalued stock that one would like to add to their portfolio. Emergency funds can also allow for opportunity purchases (not to be confused with discretionary "spending" that should be part of a monthly budget).

My emergency savings have seen me through changes in employment, appliance and vehicle repairs, home improvements and travel opportunities without any disruption to long term investment plans. I also do not include my emergency savings in my "asset" calculations. It is money that is designed purely for Emergencies and Opportunities. If I dip into it, I replace it at the first opportunity by cutting back on my discretionary spending for a period of time.

Stephen Weyman's picture

Your points are very good ones and basically sum up why most people recommend having an emergency fund and I do agree with all of them to some extent. Having an emergency fund is the right decision for a lot of people.

However, I'll give you my contrarian take on each of your points.

1. I think if you combine all the things I mentioned, you definitely have liquidity available to you. If you have one or two lines of credit, a credit card that can take a cash advance, investments you can borrow against or sell, etc then you should have access to cash at a low cost whenever you need it.

2. This I feel is the strongest point and the strongest reason why people shouldn't do this. Only people who can handle it psychologically should do it.

3. This is sound advice for most people but maybe not the best advice for everyone. Someone who is a disciplined spender and not inclined to impulses can end up ahead by simply spending what money they need to when they need to and aggressively paying down debt and investing the rest.

4. This is covered by point 1. You will still have lots of available cash to take advantage of opportunities.

Thanks for your perspective!

Saver Gal's picture

I disagree with going to a credit card or a line of credit for a financial emergency unless absolutely necessary. What's the point of paying down a mortgage, only to incur much higher credit card or Line of Credit interest. That's kind of like robbing Peter to pay Paul. The way to grow your net worth is to save, reduce debt and be tax effective in your planning....budget to find the money to reduce debt. Direct the found dollars to savings. Save even more by investing in tax advantaged investments when appropriate for your risk tolerance and time horizon...have a TFSA and an RRSP if your income is high enough to generate significant a tax refund.

Stephen Weyman's picture

I agree with doing ALL of those things, and by using your emergency fund dollars you should be able to do MORE of it.

1) Big emergencies should not happen often so the amount of time you spend in an "emergency state" should be MUCH less than the time you spend in a "normal" state. The long time period while you are in a normal state will benefit from the increased investments earnings and savings from increased debt pay-down.

2) I disagree with line of credit interest being much higher than your mortgage. For the entire period I had my mortgage my line of credit interest was lower than my mortgage. My mortgage was at 5.05% fixed and my line of credit was at 3% tied to prime.

Even if 2) is not true for you and your line of credit interest is higher you do have other options like a 0% interest credit card as mentioned in the article. If you have to use your line of credit, then paying 1 or 2% higher interest than your mortgage until you pay off the small balance on your line of credit will be easily trumped by the extra money you now have from 1). Just focus your debt pay-down from the time of emergency forward to whatever loan has the highest interest rate.

I understand that this strategy is not for everyone and there are valid arguments to be made against it. However, if followed perfectly without the involvement of human emotion and psychology, this strategy will win almost all the time assuming that big emergencies are relatively uncommon.

Jakob's picture

I second Saver Gal's take on the issue.

Your post has a lot of good ideas, but you've also decided to contradict yourself in a minor way: in one spot you claim (correctly) that people usually have lots of unused contribution room for RRSPs and TFSAs, in another spot you say there's no reason why the money should be wasting away in a low-interest, taxed savings account.

Well, one very good solution is to put it into a high-interest non-taxed savings account. My TFSA at Canadian Direct Financial is currently earning me more than the interest charged on my mortgage (admittedly, prime - 0.9 was a great deal back then), and other credit unions like People's Choice offer even better rates. That money can be withdrawn any time and offers both decent returns (for an emergency buffer) as well as the opportunity value mentioned by Saver Gal.

If you've maxed out your RRSPs and TFSAs and have to worry about being taxed on your emergency buffer, chances are you make enough money that the emergency buffer only covers a negligible bit of your overall returns and the win in returns doesn't really justify the bigger risks in the big picture.

Stephen Weyman's picture

Sure, if you can get a better rate on your TFSA that you haven't maxed than your mortgage, go for it! I think this would represent an extremely small percentage of the population though. For most people it wouldn't even be close.

You really have to hunt for those high saving account interest rates as well, and those accounts come with some slightly higher risk as well as the institution may be more at risk of default than a large bank. Of course, there is CDIC insurance up to $100,000 to cover that except for in the Doomsday Scenario.

People's Trust currently has a 3% interest rate on their TFSA account which is higher than the 2.25% it looks like you're getting. Most people don't have an account with them though.

The highest interest rates tend to fluctuate heavily too and are often promotional in that they only last for a few months before they drop down. Your mortgage interest rate isn't going to fluctuate unless you have a variable rate mortgage.

Sébastien's picture

Great article, there are some very good points in it !

And to everyone who commented saying Stephen is wrong, just keep in mind this strategy isn't for everyone. One should always look at one's rates and one's credit score. And the only one good argument against this strategy that I've read in the comments is the psychological one : if you *feel* insecure about it, then just don't do it. Your mental health is in no way less important that any interest you can get from an investment.

That being said, there's one form of low interest credit you haven't mentioned which could be a lot of help to someone who either doesn't own property or haven't paid enough of the mortgage balance to get a HELOC. It's a secured line of credit : you make up your emergency fund out of relatively secure medium interest unregistered investment and use it as a guaranty to get a better rate out of a regular line of credit. That way you get the best of both worlds !

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