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.

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FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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13 years ago

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.

Tax Resource
13 years ago

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?

13 years ago

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.

13 years ago

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.

Roshawn @ Watson Inc
13 years ago

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

13 years ago

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

13 years ago

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!

13 years ago

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.

Cash Instinct
13 years ago

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.

13 years ago

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.