Emergency Funds 201

This is an email I wrote to the author of The Simple Dollar in response to his article detailing an approach I think builds on his idea but I feel is much better.

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I always enjoy your articles.  You're a good writer, your comments are relatively succinct, and spot on.

So this reaction is the exception.  I want to take issue with a comment in this article that I *strongly* disagree with.

"Also, never, ever have an emergency fund that consists of a credit line"

I think it's extremely prudent to have a line of credit in case something goes wrong.  I'm a fan of cash-like reserves, but the reality is, if you have any debt, instead of having cash sitting earning essentially 0-1% interest, you could be essentially earning that debt interest rate as a rate of return. 

For example, as a self-employed person, I believe strongly in having safety reserves -- I have more ups and downs than an average person.  However, as soon as I make money, I instantly use it to pay down whatever debt I have -- making sure that debt allows me to borrow back against it as soon as I need money again.  Now if the debt is such that it does not allow one to borrow back without fees (credit cards charge 3% fee for borrowing cash -- ick), that wouldn't make sense (and I have none of that debt).  But what I would argue would make more sense is to go to a bank and setup a 5-50k line of credit at 5-7% (very common, very easy to do, usually a 1x charge of $50 to setup).  Have it sitting there as essentially a cash reserve, and then use whatever cash reserves you have to pay off any debt.  This keeps liquidity that's essential for emergencies while optimizing for interest payments.  If your debt is at 5-25%, you're essentially investing your cash reserves at that rate of return, safe, with liquidity to pull it out at any time.  I've used this strategy for 6+ years very effectively.

Playing Devil's Advocate.  The argument against this is what happens if the bank reduces the line of credit (I recommend having an amount higher than you need).  Or what happens if the bank closes the LOC all together (which is why I recommend having a line at more than one bank).  Neither of those situations has happened, but they're possible, and it's wise to have thought through and prepared for what can go wrong.  Obviously, another problem is what if the person is unable to control their spending (not a problem I have), then this solution would not apply to them.  This is designed for people who are not irresponsible.

Based on how I see it this solution of having a line of credit at a bank is inexpensive to create (usually $50-$150 one-time setup fee), offers much more safety than pure cash reserves (instead of 3-5k available for emergency, there's 5-50k), all your money is working for you at credit card interest rates instead of losing 3% in net inflation.

For a reader who has some basic credit card debt, and could get a simple LOC at a bank, your cash-only reserve solution is essentially costing readers 10-25% a year unnecessarily.  I think there's a better, more frugal, safer way.

As a huge financial perk, I would argue it also allows one to seize a killer buying opportunity if it comes along that might otherwise be missed.  If someone is gets desperate and needs to unload their car for 10k cash that's worth 17k, you could write the check and save (relatively) a huge amount of money.  You've now saved your family a huge amount of money (especially considering after tax dollars - a huge hidden perk of frugality).  And if you don't need it, you could flip it for easy profit.

Lastly, I would argue that the size of your emergency fund (regardless of cash or LOC) should also have "job stability" as part of the variable.  I think self-employed person, or someone with a high degree of stability risk should make sure they have access to more funds than say a tenure teacher.

I think the concept of Emergency Funds that you covered is very important.  Unexpected emergencies that one is unprepared for can take out years of hard work and otherwise perfect planning/work.   I think the elements of utilizing a LOC and ratio'ing the safety amount to stability also improve one's ability to succeed.

I'm open to other thoughts if you see a hole in my thought process.