Using a Line of Credit as Emergency Cash

People used to say that you should always have 3 months living expenses in your “emergency savings”. When reading “The Intelligent Investor” they claim that you can increase you position to 100% stocks (risky) if you meet a number of criteria, one of which is liquid assets to pay for living expenses for 1 year.

I’m the last person on earth to say “live for today, don’t bother saving”, but the idea of an emergency money pool of cash strikes me as a fallacy. Obviously you need to be able to weather the storm of not earning income for a reasonable period of time (I’m working towards getting this period of time to be the rest of my life, and that’s a big project), but like anything there’s more then one way to accomplish this.

Given my estimated monthly costs of $2,140 in order to survive without earning money for 3 months someone might suggest I keep $6420 ($2,140 x 3) in my checking account.

Since I wouldn’t need the entire amount immediately (just one month’s expenses per month), a slight improvement would be to have this money in a safe, liquid investment (perhaps a cashable GIC, money market account or high-yield savings account). While I’m waiting for the emergency to strike, I would be earning a small yield on this money (say 3% after tax, maybe 1% after taxes and inflations). If the emergency never hits and I keep this fund around for the next 35 years until I retire, I’ve paid a HUGE price to have this “insurance” (considering some use 5.5% as returns after tax and inflation on conservative dividend paying blue chips).

$6,420 compounded at 1% annually over 35 years would be $9,094.59, whereas $6,420 compounded at 5.5% annually over 35 years would be $41,818.76.

So what’s the alternative you ask? Simple. Go into your local bank, and set up an unsecured line-of-credit (LOC). If you have a decent credit rating and income, they should happily give you a pretty large balance at a few percent over prime (I got an offer out of the blue from TD for $10,000 at Prime + 2.75%, they recently offered to increase this to $20,000). Obviously at this rate you wouldn’t want to borrow from this account unless it was a VERY good investment, but it is well suited to use as an emergency source of funds. If I have 3 months without income, I simply withdraw what I need to survive from the LOC every month. A LOC works just like a cash advance on a credit card (you get the money immediately, and immediately start paying interest on it until its re-paid), except that its a FAR more reasonable interest rate.

Then once money starts coming in again, I pay off the LOC before anything else (paying it down will likely be the best investment available to me). With a $20,000 limit, and spending $2,140 / month I can go 9 months without earning income, even with interest factored in. For full disclosure, there’s usually a small monthly minimum payment (3% or $50 whichever is more), but you can juggle money between accounts, or pay this from passive investments or whatever.

This allows me to put all my cash into long term savings, get it working as hard as possible for me, and at the same time have a cushion to deal with unexpected emergencies. If I can see a period of unemployment coming up (currently my contract is over at the end of September, so I can expect to not get paid for a while if I don’t renew it and don’t look for another job), I can keep money available to pay my living expenses (and avoid the LOC interest charges), but this is different then saving money for UNEXPECTED periods without income.

If I ever encountered a longer period of not earning money (say I became disabled or suffered major depression), I’m in trouble regardless of however I’ve structured my finances (unless maybe if I’d bought disability insurance), so a pot of “emergency funds” isn’t going to help all that much (it just puts off things getting bad for a couple of months longer than it would have otherwise). I’d probably just start liquidating long term assets as needed (sell my condo, sell my stocks) and when everything ran out, throw myself on the mercy/charity of friends/family/government (not a fun idea).

This would work the same way for other unexpected costs (such as needing a new appliance, roof repairs, vet bills or a new car).

Any other ideas for the best way to deal with short term financial emergencies?