Don't rely on credit for your emergency fund

By Philip Brewer on 9 February 2008 17 comments
Photo: Philip Brewer

There's a large group of financial advisors who suggest using credit in place of an emergency fund. That way, you can invest your entire portfolio for maximum return (such as in the stock market). This works great during good times, but it can fail badly during times of economic stress--which is just when you need an emergency fund the most.

Having all your assets are invested for maximum return (whether in stocks, bonds, real estate, gold, or more exotic options), makes a certain kind of sense. In case of an emergency, you can charge your emergency expenses on a credit card (or a Home Equity Line of Credit). If the resulting debt isn't too large, you can just pay if off out of future savings, and then go back to putting money into the stock market. If necessary, you can sell investments to repay the debt, but you can sell them at a time of your own choosing, taking into account market conditions and tax considerations.

This strategy has worked fine for the past twenty years, but it fails badly during severe economic downturns--and there's some reason to fear that our economy is heading that way again. And, even if the current economic stresses aren't the beginning of a severe downturn, there will inevitably be one eventually.

Paul wrote last week about UK banks slashing credit limits--in many cases, to the point where card holders have no credit to draw on. The same thing is happening in the US, where lenders such as Countrywide Financial have cut credit limits from 90% of the value of the home to 85%--or even to 70% in southern California and Florida--which means that many people who still had some available credit no longer do.

These sorts of moves are just the beginning. As economic stresses accumulate, access to credit will be cut off for all sorts of reasons. Already things that might just have trigged a fee, such as making a payment two days late, or briefly exceeding a credit limit, are resulting in the account being suspended. I rather expect that lenders will step up their efforts to monitor the borrowers more closely, so that they can cut off credit if someone loses a job or gets arrested. Since there's no formal mechanism for reporting such things, you can expect mistakes to be made--meaning that access to credit can be cut off for no reason at all. It will be restored within a few weeks in those cases, but that's not soon enough, in an emergency.

Of course, some people use credit for their emergency fund not because all their other assets are invested, but because they don't have any other assets. They've been plowing all their savings into paying off debt, counting on the fact that they're adding some breathing room between their balance and their credit limit to use in case of an emergency.

There is inevitable tension between reducing total debt and accumulating some cash for emergencies. In that situation, I suggest accumulating one month's minimum spending in cash, and then going back to paying the debt off as quickly as possible.

The bottom line is that your emergency fund needs to be your money, and access to credit is not good enough. Your emergency fund needs to be in cash, not invested in stocks, real estate, or classic autos. And, at least part of it needs to be accessible in your home town within one business day. It's fine to have part of it in an internet savings account, money market fund, CDs, savings bonds, or t-bills--any investment that can be turned into cash at a specific price in a specific time-frame. But part of it should be in your home town, for those cases where you need it today. Access to credit has worked okay for a long time, but it can't be relied upon when things get tough--which is when you need an emergency fund most of all.

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Guest's picture

Yup. Our emergency fund is currently in a 13-month CD. It’s earning 5.5 percent, at least for now. I hate to think how low the new rate might be when the CD matures in August. Accessibility to that money is important, though, so we’ll take whatever we can get.

Guest's picture
Minimum Wage

What about people who have neither cash nor credit nor assets?

Guest's picture
Tim H

You're just a one-trick pony. With minor variations, you post the same thing on every blog you visit. It amounts to trolling.

Guest's picture

Personally I think a HELOC is good enough. Of course *some* cash is good, even if its cash under your mattress. During big emergencies like natural disasters, the local economy will be all cash. But for the most part I keep a HELOC and some cash in e-savings but the majority invested.

Philip Brewer's picture

But banks are already cutting off access to lines of credit for their poorer customers. If the economy turns down further, they might well cut off access for their good customers as well.

Access can get cut off when the whole economy is doing poorly (which is just the sort of time that an individual has an emergency). It can also get cut off just for one individual, if that person has a financial emergency. The banks don't usually know when someone, for example, loses a job--but I'm sure they're hoping to get some visibility into that sort of situation, specifically so that they can cut off someone's access to their line of credit, if they're ever in a situation where they might want to use it.

Guest's picture
Minimum Wage

Yup. Our emergency fund is currently in a 13-month CD. It’s earning 5.5 percent, at least for now. I hate to think how low the new rate might be when the CD matures in August. Accessibility to that money is important, though, so we’ll take whatever we can get.

If accessibility is important, you might consider multiple "laddered" smaller CDs with staggered maturity, so that you'd have at least one CD maturing every month or two.

For example, instead of one $10K 13-month CD, how about ten $1K CDs maturing a month or two apart.

The smaller CD will probably fetch a slightly lower yield, but that might be a better deal than the penalty for early withdrawal of a 13-month CD.

Guest's picture

'There's a large group of financial advisors who suggest using credit in place of an emergency fund.'

I think that's simply not true. I've been a financial advisor for 13 years and that's probably the last thing I would ever tell somebody.

I'm sure it's happened, but to say a 'large group suggest this' is plain wrong. Where are you getting this information? I'd like to hear it.

The advisory business has received quite a few black eyes and I think it faces a crisis in certain respects, the last thing they need is to take the blame for something like this.

People that use HELOC's or any other form of 'overdraft protection' as an emergency fund are generally doing so on their own or against the advice of any capable financial advisor, I think the word for it is 'greed.'

Philip Brewer's picture

I didn't mean to imply that a large group of "certified financial planners" (or any other group of people trained in the field) advocate this strategy, just that a lot of people who informally offer financial advice do.

I first ran into the idea in an article in the Wall Street Journal sometime in the mid-1990s (the dotcom bubble was just getting going). In that case, it was part of a whole strategy that included putting 90% of your money into stocks and 10% into zero-coupon bonds with a maturity that matched your planned retrement date. Then, when you retired, you'd get a chunk of cash from the zero-coupon bonds, which you could use to live on. The article included a strategy for selling your stocks to replenish cash that allowed for market downturns. Having all your money invested was supposed to be okay, because you had credit cards.

If you go back to most of my previous articles on emergency funds, you'll find people in the comments saying that they're relying on credit cards or HELOCs for emergencies, and I've seen other financial bloggers make the same suggestion.

Here's some I found in 2 minutes of googling:

So, I thought it was worth advocating against.

 

Guest's picture

Minimum Wage wrote: "If accessibility is important, you might consider multiple 'laddered' smaller CDs with staggered maturity, so that you'd have at least one CD maturing every month or two."

Cool, that's great advice, Minimum Wage, and I totally agree.

Sorry I wasn't very clear in my post—the main part of our emergency fund, enough to cover up to six months' of basic expenses, is in the CD with the best rate at our local hometown bank. We have three other smaller CDs there also plus yet another in a bank in a neighboring town (where I've been a customer since I was an infant), currently earning 5.35 to 5.40 APY, and maturing at various times of the year. Those other CDs are earmarked for various trips and projects but could be used immediately in case of emergency. Actually, the one time we needed to withdraw one due to an emergency, the friendly lady at the bank already knew about our situation and waived the penalty. That's one of the perks, I guess, of having a long-time relationship with a local business.

Guest's picture
Chris

I have thought about this many times. I have an Emigrant Direct savings account that is wonderful. However what if we had a global disaster. Would I be able to get my money out? I would like to think so but the logical part of me says no. Therefore I am an advocate of keeping a months worth of cash in your house. I would go as far as to say it would not hurt to keep a little gold bullion too.

Guest's picture
Durbo

I think this issue is really about risk. Are you willing to risk that in an emergency, your credit will be available?

I personally, based on my situation, have decided to take the risk. I have used credit for during an emergency in the past and it has worked fine. I invest my "savings" in my line of credit to reduce the amount of interest I pay overall.

I should advise that I live in Canada and have good credit. The slow down in the USA has not hit us yet (although it may hit in the near future). In that event, I may re-evaluate my strategy.

Guest's picture

This is an interesting blog on the emergency fund. I am firm believer that your emergency fund should be in an easily accessible, but not too easy place. It must be liquid, I recommend a money market fund with check writing privileges. Using a credit card for your emergency fund is not wise in my opinion. If you cannot pay off your credit card every month, you have too much credit card debt.

Guest's picture

Hey Phil,

Wish you guys had the 'get additional comments' button here, I wasn't aware this thread was ongoing... thought it was kind of strange that you didnt respond to my remarks, ha.

For me, I think it's important that you make the distinction between professional advisors (CFP or not) that are compensated for their advice vs. not (the legions of personal finance bloggers that talk 'their book.' etc.)

When you use the term 'financial advisor' I take it to mean someone who does it for a living. I would be a bit more descriptive going forward, so the 'believe what they read' segment won't be confused about who you're referring to.

Guest's picture

Oddly, the comment count doesn't seem to be updating for this post on Philip's main page.

It is an interesting discussion, though, and I like reading about other people's strategies. I'm a risk-averse person, obviously. I'm actually thinking that the best investment for our money this year will be retrofitting our home for even greater energy efficiency. We'll focus on that as soon as we make the last mortgage payment in late April or early May.

Philip Brewer's picture

Yeah, there's a known issue with the comment counts. The admins know that it happens on an occasional post, but haven't been able to figure out what's going on.

Making non-financial investments (such as insulating your house, buying good tools, or stocking up when there are good sales on grocery items) is often a more profitable choice than investing in stocks or bonds.

Guest's picture
steve

"Making non-financial investments (such as insulating your house, buying good tools, or stocking up when there are good sales on grocery items) are often both more profitable" than purely financial investments because they are real, not abstracted, and have a "real" practical effect that you can enjoy. They are in my view the most fundamental form of investment--and generally involve making some systemic/infrastructural change that increases your bottom line by either making existing expenses in energy or time more efficient, or by decreasing your need for a given item.

Guest's picture

"This strategy has worked fine for the past twenty years, but it fails badly during severe economic downturns"

Following the economic downturn in the past few years, what do you now think about this?

Personally, I think the key is understanding the availability of credit and reacting accordingly. If you have sufficient credit readily available, then it can have a seriously detrimental impact on your long-term wealth keeping an emergency fund in low interest paying accounts:

http://moneystepper.com/emergency-fund/