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Debt Free Revolution published an interesting post today on why she likes to have a cash emergency fund and hates the idea of using your HELOC for your emergency fund. I thought I better write a post to address this idea since having a cash emergency fund is not always the best way to manage your money.

I use my home equity line of credit (HELOC) as my emergency fund because I believe that having too much cash on hand is not good money management.

Some problems with keeping a cash emergency fund:

• tax inefficiency – the interest earned on the emergency fund is taxed at your marginal tax rate. If you earn 4% interest and have a marginal rate of 30% then your net interest is only 2.8%.
• higher debt costs – using all your cash to pay down debts will keep interest on your debt lower than if you kept your money in an emergency fund.

Let’s look at an example:

Two homeowners – let’s call them Mike and Ana, both have mortgages of \$200,000 at 5.19% and they have \$10,000 each in cash. Ana likes the idea of keeping the \$10,000 in cash as her emergency fund while Mike prefers to pay down the mortgage with the cash and will use a HELOC if an emergency comes up. Both mortgages have interest-only payments for simplicity.

So we have:

Mike – mortgage = \$190,000, cash = \$0.

Ana – mortgage = \$200,000, cash = \$10,000.

Scenario I

An emergency occurs after one year and both home owners have to cough up \$10,000. Ana has the cash on hand and Mike borrows \$10,000 from his HELOC.

How do the home owners compare in this scenario?

Mike – mortgage = \$190,000, HELOC = \$10,000, payments = \$9861, total debt = \$200,000.

Ana – mortgage = \$200,000, cash = \$280, payments = \$10,380, total debt = \$200,000.

Both home owners end up owing exactly the same amount however Ana has \$280 (net of taxes -30%) of interest on the emergency fund but Mike has paid \$519 less in interest which tips the scales to Mike and his HELOC emergency fund.

Scenario II

There is no emergency.

Mike – mortgage = \$190,000, HELOC = \$0, cash = \$0, payments = \$9861.

Ana – mortgage = \$200,000, cash = \$10,280, payments = \$10,380.

In this scenario, after one year, Ana has netted \$280 in interest but Mike has paid \$519 less in interest on the mortgage so Mike comes out ahead.

What does it mean?

From the example above it should be pretty clear that using a HELOC is cheaper than using a cash emergency fund for some situations.

There are factors which should be considered which might make the cash emergency fund a better choice:

• If the home owner doesn’t have a HELOC or other low interest credit then a cash emergency fund might be a better plan. Using a credit card as an emergency fund is not a good idea.
• If the home owner doesn’t want to worry about exactly how much cash is in his/her account then having extra cash might be a good idea. Keeping a low cash balance can mean bounced cheques and late payments if the home owner is not organized.

Conclusion

There are some situations (like mine) where using your HELOC (or regular line of credit) as an emergency fund is the best way to manage your cash. On the hand there are other scenarios where a cash emergency fund makes more sense. It’s up to you to learn the various pros and cons of both methods and apply one method or a combination of both methods to your situation.

Some other posts on this topic:
Mr. Cheap is a fan of line of credits
The Financial Blogger says that cash emergency funds are wasteful.
The Money Gardener explains why he doesn’t like having cash.
Million Dollar Journey says he relies on a combination of cash and a line of credit in an emergency.
Never one to follow a crowd, Thicken My Wallet likes the cash method for emergencies – the more the better.