So You Think You Don’t Need an Emergency Savings Account Because You Have a ….

I hear this every week with clients: “We do not need an emergency savings account, we have…”:

  1. Short and long term disability
  2. Brokerage account with loads of assets
  3. HELOC (home equity line of credit) we can draw upon when we need it, and it has a great rate.

Let’s discuss this, shall we. There are 3 reasons to draw on your Emergency Savings and I will add a fourth that is really an asterisk.

  1. Divorce – one of the greatest wealth killers and bankrupters
  2. Disability – either injury or illness
  3. Job Loss

* to supplement your Rainy Day Fund ($3k for homeowners) for an unexpected large home repair (e.g. a roof replacement).

Your disability plan may be excellent from your employer and that’s a great benefit to have, but unfortunately, it will not help you with 2 of the 3 Emergency Items. Plus, you may have bills or treatments that are way more expensive than you can afford living on your disability. You may need a driver or childcare. Most disability policies (short and long term) have elimination periods or periods where they do not pay. Elimination periods for long-term disability can be 90 days with some policies. What will you do then?

Unemployment benefits are like disability insurance for losing your job. True, except it will pay pennies on the dollar of what you make now. It’s excellent and you should apply for it if you get laid off, but it is not going to pay the mortgage.

A solid brokerage account is good to have for long-term savings, ONCE you have filled your Emergency, Rainy Day and retirement savings buckets. If you need money fast because the roof caved in or you are suddenly disabled or unemployed, you could potentially have an enormous tax bill if you liquidate brokerage funds.

If you keep a bunch of money in cash or money markets in your brokerage account, that is a different story and it can be used as an Emergency Fund. Money in stocks, mutual funds, bonds, bond funds or any other illiquid asset is not an Emergency Fund. It could be very costly to liquidate it on the day you need it, either due to taxes or the market being down on the day you lose your job (think 2008) or both.

Your HELOC… I love this one. HELOC’s are great to have for many reasons including actually doing upgrades to your home, consolidating credit card debt at a better rate and other strange financial things that come up for regular people, but do not take on debt when either of the 3 Emergencies listed at the top of this article happen.

You do not want to service more debt when you have to buy your spouse out of his/her half of the house in a divorce or have to set up a new household. Cash flow will be tightest then and another debt payment will hurt. The HELOC has to be paid if you refinance or sell the house, which means it will be a big problem if whichever of the three emergencies you are experiencing requires you to sell your home (which happens a lot).

You would not want to service more debt when you have enormous medical bills for a sudden disability. Again, cash flow will be tightest at this point and more debt payments would be unwelcome. You may even need your HELOC for additional medical bills as disability/illness is one of the biggest bankrupters out there.

And of course, servicing more debt when you are unemployed sounds unappealing. Generally, you would cut as many expenses as possible during periods of unemployment.

The cold hard truth is that you NEED TO SAVE for EMERGENCIES. Specifically, the unlikely three events listed at the top. You need 3 to 6 months at least of your monthly household expenses in cash or cash equivalents (e.g. money markets, etc.) to be fully secure financially.

Why Would You Save When You Are in Debt? Because You Have to…

Frequently cited as a reason to throw up your hands and not save, the attitude of “I have so much debt, why would I save?” could ruin you financially. Let me be clear, you always need to save for the stuff that happens in life.

What would you say I if said, “I have a 30 year mortgage at 3.25% so I cannot save any money until it’s paid off.” Would you think I was crazy? I would. You must save. All. The. Time. Sorry, it’s not what you want to hear, I know, but it is true. What happens during that 30 year mortgage if the car breaks down, the roof leaks, you need an emergency root canal or other unforeseeable events that are worse. You would have to charge them and thus you would be on the slippery slope of credit card debt.

There are different kinds of debt. Debt that is paid back over long periods of time like a mortgage or student loans with good rates and reasonable terms are different than credit card debt or some other type of consumer debt, which usually has high interest rates and possibly fees. A good solid car loan is somewhere in between.

For long term debt (duration greater than 5 years), you just want to make sure you have a good payback plan, interest rate and terms (meaning no fees for early payback, etc.). Payback of this sort of debt, i.e. mortgages and student loans, should be considered an expense over the long term and you should ABSOLUTELY be saving while you pay long term loans off.

Think about the extreme example. If you get a 30 year mortgage and have 20 years to pay back grad school loans and you are 30 years old, would you still want to save for retirement during the time your paying those debts back. HELL YES!!!! In fact, if you do not, you will probably be eating dog food in your dotage. Regular savings is just like retirement. You will need it at some point, so save.

Now, let’s look at a few of my savings rules

  1. Do not rush to pay off debt until you have a Rainy Day Fund ($1500 for renters and $3k for owners) AND at least ONE MONTH of Emergency Savings for the big 3 (divorce, disability or job loss). One month is equal to one month of your household expenses.
  2. When your Rainy Day Savings and AT LEAST 1 month of Emergency Savings are in place, make sure you are contributing 15% total each year for retirement if you are over 35 years old. This INCLUDES your employer contribution.
  3. THEN, and only then, can send any extra at the end of the month, tax refunds, annual bonuses to your credit cards. Generally, I advise people to split the extra amount they have between debt pay down and savings until they have at least 3 months of Emergency Savings. When you have at least 3 months of Emergency Savings, use the extra to pay credit card debt off exclusively.
  4. Do not worry about student loans AS LONG AS you can manage your monthly payment and you are on the optimum payback plan for your life and career. They do not affect your ability to get a mortgage as long as you can adequately manage the payments each month.
  5. Do not rush to pay off your mortgage early unless you have 6 months of liquid savings for Emergencies, a Rainy Day Fund, retirement contribution at 15% at least and you are consistently saving for college (if you want to help your kids with college). Then go ahead and make extra payments. Otherwise, do not rush.

All this anti-debt propaganda is not helpful. Credit is leverage. It helps you buy a home and build equity before you are 70 years old, it helps you go to school to earn more. It’s only bad if you abuse it and incur credit card debt at high interest rates or otherwise over extend yourself. If you've already done that, trim spending, make sure you are saving appropriately, and start paying it back as fast as you can.