Emergency funds are the best way to protect your finances from harm when an urgent expense arises. They provide a shield to prevent you from having to take more damaging action that will have long-term repercussions to you finances.
It’s recommended that everyone hold 3-6 months of expenses in their emergency fund, held in a high-yield-savings account. This ensures that in the case of a job loss or an unexpected expense, you can take care of it without having to take on debt, or fire-sale an asset.
A traditional emergency fund is always best. An emergency fund exists to deal with emergencies without having to take action that damages your financial life. If you didn’t have an emergency fund, you may take on expensive debt (e.g. credit cards) that take years to pay off, and damage your credit score. Or you may have to sell an asset urgently (e.g. home/car), resulting in getting a lower sale-price. These situations can be avoided with well-funded emergency fund.
Now as much as having an emergency fund is the recommendation, there may be cases where you find yourself without one in a crisis. Though this is not ideal, there do exists less attractive alternatives. These alternatives have considerations and some are certainly better than others. In this article we will explore what these alternatives are, and the things you need to know for each one.
Credit Cards
In a pinch, credit cards present an easy option to get quick access to money. But credit cards often have a very high (20%+) interest rate on a balance that is carried between billing cycles. You also need to be approved for a credit card before you need the funds.
As such, credit cards may be used for anything immediate, but you should explore other options to pay off the balance at then end of your billing cycle to avoid the high interest.
Home-Equity Line of Credit (HELOC)
HELOCs represent credit that is collateralized by the equity in your home, meaning that if you default on the loan, the creditor can seize your home. Because the loan is collateralized, the interest is typically much lower (slightly higher that your mortgage rate). HELOCs also allow you to pay just the interest, which can keep payments low.
Using debt for an emergency is never ideal, but if necessary, a HELOC is one of the best options, so long as you can pay it back.
Un-Secured Line of Credit (LOC)
An un-secured line of credit represents credit that is not guaranteed by any collateral (e.g. a home), and opening an LOC requires approval from the lending institution (e.g. bank) in advance. As such, the interest rates are higher than a secured LOC, but not as high as a credit card.
Again, due to the high interest rate, this option can be used in a pinch, but should be paid off as soon as possible to minimize interest costs.
Withdrawing From an Investing Account
In the case of emergency, you may need to sell some stocks and withdraw that cash to take care of that emergency. Now there’s no immediate cost associated with this (expect transaction frees), but the big danger is the opportunity cost. Historically, the stock market has returned ~10% annually, and by withdrawing that money, you’re eliminating the potential for future growth. This could have long-term consequences for your wealth.
Whenever possible, withdrawing from an investing account should be avoided.
Withdrawing From a Registered Account
Withdrawing from registered accounts (e.g. RRSP/401k, TFSA/Roth IRA) can often come with penalties or conditions, which is why it’s not recommended to hold emergency funds in a registered account. You may pay a tax on the withdrawal, and lose contribution room. As well, just like withdrawing from an investing account, you can stunt your investment growth for many years to come.
Due to the potential penalties and opportunity cost, withdrawing from registered accounts is not recommended
Short-Term Loans
Short-term loans are typically offered with terms of less than 12 months, and can come with incredibly high interest rates. They often offer very quick access to cash, but you should be very careful to review the terms. Similar to credit cards, if these are necessary they should be paid off as soon as possible.
Short-term loans can be very damaging to your personal finances and should be avoided at all cost.
Insurance Policies
Insurance can be used to protect you in the case of major emergencies (e.g. home insurance, life insurance, etc.), but you can also buy insurance to cover things like car repairs. That said, insurance is not typically a one size fits all solution. What is meant by that is it’s impossible and impractical to purchase insurance for everything that could occur (e.g. covering car repairs, covering medical bills, etc.).
There are always situations that can arise that aren’t covered by insurance. As such, an emergency fund held in cash that can cover any emergency is the best solution.
Life Insurance Policy Loan
Permanent or whole-life insurance can accumulate cash value. You can borrow against this cash value to use for any purpose, with emergencies being included. Similar to other loans, this will come with interest, . Though the interest rate is typically lower than things like credit cards as your death benefit is used as collateral.
In a pinch, life insurance policy loans a great option, but a traditional emergency fund is typically best.
Borrowing from Family or Friends
In a pinch, you can lean on those around you for funds. That said, this can be very strenuous on any relationship, and typically should be avoided. Depending on your relationships, this may be something that is inappropriate or cause difficulties.
In general, borrowing from family or friends should be a last resort.
Though alternatives to emergency funds exist, holding 3-6 months of expenses in cash is the best option. This provides both liquidity and safety for your money, and allows the flexibility to deal with any emergency.
To set up an emergency fund, you need to track your spending, build a budget, and determine how much you want to save. From there, allocate money in your budget towards your emergency fund. Though it’s not always easy, taking action to set up your emergency fund will benefit you when an emergency inevitably arises.