How to manage an emergency fund
An emergency fund is an amount of money that you have immediately available for large unexpected costs and/or unexpected periods of reduced income. Many folks consider emergency cash a vital piece of anybodies portfolio and while that may be true there is also a cost to consider!
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How much should an emergency fund be
While there is alot of subjectivity here the 2 parts of an emergency fund are:
- You want to be able to cover 6-12 month of expenses (6 at minimum, 12 at most)
- If you have any liabilities like a house, dependent, car, etc you want to have enough to cover an reasonably large expense that could come up unexpectedly
Cost of an emergency fund
Let's assume that your monthly expenses are $2,000 and you want your emergency fund to cover 6 months, that means you need to have $12,000 cash. Having an emergency fund creates an opportunity cost cause it will lose value to inflation and it could have been invested in the market.
opportunity_cost = (fund_amount)*(1 + average_real_return_rate + inflation)^(years) - fund_amount
In our case lets assume 2% inflation, 7% real return, and a 30 year period where you need to maintain this emergency fund:
$12,000*1.09^30 = $149,212
You will have paid ~$150,000 or ~$5,000 a year on average for the security that a $12,000 emergency fund offers. This certainly is very expensive but there are also ways that you can reduce this opportunity cost!
Mitigating opportunity cost
If you want to maintain an emergency fund there is still several things you can do to make sure you're saving where you can:
- High Interest Savings: The easiest thing to do is leverage a high-interest savings account (HISA)! EQBank has one of the most competitive interest rates and over the last 5 years I have averaged 2% interest on my emergency fund which basically cancels out the inflation:
$12,000*1.07^30 = $79,347
Boom! With a simple HISA we have nearly cut the opportunity cost in half!* There are other banks like Tangerine which offer frequent promo interest in excess of 2% which you can find here
- Accurate fund size: Be honest about what money you would need if you lost your job, it takes alot of work to figure out what all your expenses are and most folks I know overestimate the emergency fund they need. If you could reduce your fund from $12,000 to $10,800 (-10%) your opportunity cost is reduced by ~$16,000 (10.6%)
Borrowing your emergency fund
Carrying high interest credit like credit card debt and unsecured lines of credit should be avoided at all costs! That being said there are some methods where you can leverage "secured" lines of credit to eliminate** the opportunity cost of an emergency fund:
- HELOC: As you build equity in your home the bank may provide you a second open line of credit on your house (usually at a very low rate ~prime). If a rainy day comes you can use this borrowed money to cover any immediate expenses and when your income is stable again you can direct the money you would have used to invest and pay down this LOC. The benefit of this is you remain "fully" invested
- Investment Margin: If you have unregistered investments you can use margin to effectively borrow your emergency fund at only 1-2% interest. For example if you have $100,000 invested in a unregistered account with a online brokerage (IBKR is the cheapest for margin) and you lose your job you can sell $20,000 of your investments and take out $20,000 margin position. This means that you still have $100,000 invested and $20,000 to cover your expenses, you will be taking on some risk as you could have a margin call if markets go down 60%+ and pay some interest for the $20,000 margin but it will be < 2% but that calculated risk will save you hundreds of thousands of dollars.
- Gift: It's a fairly western idea to think of your finances completely indepent of your family, for many people their parents or extended family have high liquidity and can act as a "emergency fund". For example if your parents are close to retirement and their investments are more conservative they can allow you to increase your investment risk which will allow you to get a much better return in the long run.
I'm sure I can write a whole article on this topic but just like if you have a life partner you both benefit from thinking of your finances jointly, your family can benefit from thinking about your immediate family as one unit and balance risk accordingly.
*It's worth mentioning that current interest rates are <2% (we are likely to see interest rates increase in the long run)
**Technically if you have access to any credit you are encurring an oportunity cost implicitly cause that money could be invested but in practical terms not everyone likes to be fully leveraged all the time.