Month: March 2021

Categories
Expenses General FI

Credit Scores: How they work and how to increase yours

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BLUF: Your credit score can have a substantial financial impact on your life. Many people don’t understand them, pay attention to them or put in the work this one thing that can save them or cost them a lot of money. Putting in the work to increase your credit score can save you a lot of money over a lifetime.

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What is credit?

Credit is the ability to borrow money or access goods or services with the understanding that you’ll pay later. The creditor is the person or business extending credit to you with the expectation that you pay them back the full amount at a later date including interest. Some common borrowing examples include:

  • Store cards (Target)
  • Credit cards
  • Car loan
  • Mortgage loan (home)
  • Personal loan
  • Boat / Motorcycle / ATV loan

What is a credit report?

To calculate a credit score, though, you need data. That’s where the three main credit bureaus: Equifax, Experian and Transunion come in. These companies each collect information on all the credit related activity that you have from each lender and compile that data into a credit report. This includes information like account type, payment history, loan balances and available credit.

When you use a credit report service on the internet it’s pulling a credit report from one or multiple of the credit bureaus. All of the information reported to them in that credit report then is used with FICO’s formulas to calculate a credit score.

What is a credit score?

Have you ever loaned a friend money and they didn’t pay you back? Not fun. Creditors that loan money as their business certainly don’t like it either. They needed a way to understand the likelihood that a person will pay back borrowed money so that they could decide whether or not to loan them money. The two main pieces of data used by creditors to extend credit are your income and your credit score.

A credit score is a numerical way to summarize your personal credit risk based on your credit data. The FICO score, originally developed by Fair, Isaac and COmpany in the 1950’s has become the most widely used method for calculating a credit score. FICO scores generally range from 300-850 although some industry specific scores do go up to 900. It isn’t a static formula though as they keep tweaking it and evolving it based on lender needs and consumer behavior.

[1] Credit: https://www.ficoscore.com/faq

There is a second type of credit score that exists called the VantageScore that was created in 2006 by the three credit bureaus. The VantageScore 3.0 is very similiar to the FICOScore in that it ranges from 300-850. It uses 6 categories that are similar to the FICOScore 5 categories below but are slightly different in percentage weighting.[12]

In this article I will largely talk to the details of your FICO score although I’ve used some additional screenshots and data from CreditKarma which is using the VantageScore 3.0. The tips and advice for how these scores impact your life and how to improve them still hold regardless of which score is used. If you’d like to read more about the differences between the FICOScore and VantageScore systems you can do so here.

What makes up your credit score?

The exact formula of how a credit score is calculated isn’t public information but what is known are the factors that make up your credit score. I’ll go into the factors in detail using information from FICOscore.com (FICO), myFICO.com (FICO) and CreditKarma.com (Vantage). These factors apply to all credit accounts on your credit report.

[2] https://www.ficoscore.com/education#CreditDecisions

Payment History (35% of the credit score)

Payment history is whether you make payments on time or late each month. The lateness of the payment matters as well and are bucketized as either 30, 60 or 90 days late with each step being a bigger hit to your score. Typically after 90 days late the next step is going to collections where it becomes a derogatory mark.

How much could it impact your score being late? “With a FICO® Score of 780 (on a scale of 300-850), being just 30 days late on a payment could drop your score to between 670 and 690, according to FICO. If your score was 680, having a payment reported as 30 days late could drop your score to between 600 and 620 according to FICO.” [3] Ouch!

CreditKarma.com shows this view as a percentage of on time payments. If you had a single credit card for 10 years then you’d have 120 payments. If you had just 2 late payments in that time then (120-2) / 120 = 98.3% on time payments which is already in the yellow. It doesn’t take much to impact your score so it’s best to avoid any late payments.

CreditKarma.com view of my VantageScore 3.0 payment history

Derogatory marks such as a bill that goes to collections, a bankruptcy, tax lien and civil judgements. Even a single derogatory mark is high impact and the worst part is that they can stay on your credit report for 7-10 years!

If you thought late payments had a negative impact on your score, hang onto your hat for the impact of a bankruptcy. “Bankruptcy could have an even bigger impact, according to FICO, potentially dropping a FICO® Score of 780 to between 540 and 560, while a 680 score could fall to between 530 and 550.” [3]

It is important to note that a late payment or a derogatory mark does negatively impact your score immediately, but that score impact starts to fade over time if you don’t have any other bad marks.

CreditKarma VantagScore 3.0 view of my derogatory marks

Amounts Owed (30% of the credit score)

There are 5 different factors that FICO uses in the amounts owed category that feed into the 30% weighting:

  1. The amount owed on all accounts – Even if you pay off your cards in full you’ll almost always show as having a balance on your credit report. This is just the timing of when the balance is reported compared with your payoff date.
  2. The amount owed on different account types – The type of account like an installment loan for a car is viewed differently than a revolving credit account like a credit card.
  3. How many of your accounts have balances – If all of your cards have a balance you appear to be higher risk than a borrower with mostly zero balances.
  4. How much is owed on an installment loan compared with the original loan – If you take a $200,000 mortgage your credit score will improve as you go from a balance of $200,000 (100%) to $160,000 (80%)
  5. Credit card usage ratio – This is the total balances / total available credit. Just like with #1 your credit report likely won’t show a zero balance even if you pay off your cards in full because of the timing of reporting the balances. Example – if you owe $500 on a $2,000 limit card and $1,000 on a $15,000 limit card then your usage would be $1,500 / $17,000 or 8.8%. [4]
CreditKarma VantageScore 3.0 card usage view.

Length of Credit History (15% of the credit score)

The length of your credit history deals with the age of the credit accounts on your credit report. Very logically, the longer you’ve had lines of credit and shown responsible use of them, the lower the risk you are to a lender. There are three things that the FICO score takes into account in this category:

  1. How long your credit accounts have been open including the age of your oldest account, the age of your newest account, and an average age of all your accounts.
  2. How long specific credit accounts have been open.
  3. How long it has been since the account has been used.[5]

CreditKarma shows you information on the average age of open accounts which is doing just that – averaging the time each account has been open across all of your open accounts. 7-8 years on average is the start of the good area for a VantageScore 3.0 so as you can see this kind of thing takes time. This is one reason why it’s bad to close old accounts if you aren’t using them. It could substantially drop the average age of your credit.

Snapshot at CreditKarma VantageScore 3.0 showing how long accounts have been open.

New Credit (10% of the credit score)

When you attempt to open up a line of credit there is what’s known as a hard inquiry to your credit report. These hard inquiries stay on your report for two years although only one year is used to calculate your FICO score.[6] There are three main items that FICO looks at in the new credit category:

  1. The number of new accounts that you have.
  2. How many recent inquiries you have – this is anytime that a lender requests your credit score or report. When this is done to open an account it’s known as a hard inquiry and is more impactful on your credit score. A soft inquiry on the other hand does not impact your credit score. Soft inquiries include things like checking your credit score personally, getting a copy of your credit report and getting pre-approval from a lender for credit.[7]
  3. The time since opening up your last new account – borrowers who open many new accounts in a short period of time are higher risk.[6]
Accounts opened within the last two years show on your report.

Hard inquires stay on your credit report for a little more than two years. Their impact on your score is still minor and that impact also decreases over time.[7]

Hard inquiry view from CreditKarma VantageScore 3.0.

Credit Mix (10% of the credit score)

Credit mix refers to the different types of credit accounts that you may have on your account. There are two main types of accounts:

  1. Revolving credit accounts – these are accounts with an established credit limit that you can reuse and make payments on. Examples include credit cards, retail store cards, gas station cards and even a home equity line of credit (HELOC).
  2. Installment loan – a fixed balance is paid off progressively over time. Examples include a car loan, mortgage loan, student loan, furniture loan, boat loan and motorcycle loan.

I wouldn’t create new loans just to satisfy the mix the accounts here being that it’s only worth 10%. To me this is just something to be aware of as a low credit impact.

What credit score is good?

That’s how credit scores work, but what is a good credit score? The table below is a good general guideline for what each score means for a FICOScore.

[11] FICOScore.com breakdown of what each score range means.

To qualify for the best credit card offers you often need at least 690. In the mortgage example down the article the top rate is achieved at a 760 FICO score. Once you’re in the upper 700’s you can feel pretty confident that your score is good enough to get the best rate.

How a credit score impacts your life:

Okay, enough going on and on about how credit scores work. Why should I care? How does this impact my life? Well, your credit score follows you forever and is used in an increasing number of ways because it’s an easy assessment of risk based on your consumer behaviors. Here are examples of life situations when your credit score and/or report are used:

  • To qualify for a loan – Fairly obvious but your credit score is a big part of being approved or denied for a loan. Each lender has their own standards for risk and if your score is too low many lenders will deny you.
  • To determine the interest rate offered on any loan – if you are approved for a loan, the rate that you pay is HIGHLY dependent on your credit score. See the mortgage example in the next section. This translates into a low credit score costing you a lot of money over the course of your life.
  • To get approved for the most lucrative credit cards – who doesn’t love cash back and travel rewards? Unfortunately only high credit scores are eligible for the best cards. If you don’t have at least a 700 score you can’t get the best cards.
  • To rent a place to live – Landlords sometimes check your credit. A landlord isn’t extending credit but they do need to be paid monthly just like an installment loan. They want low risk tenants that will pay reliably. They may not rent to you or ask for a larger security deposit. Foreclosures and evictions show up on a credit report which could be grounds to deny your application.
  • To get insurance – insurance premiums are payments and insurance companies they want their money. You could receive higher rates or be denied if you credit report shows a poor payment history.
  • To get a new job – they need written permission but prospective employers can request a copy of your credit report. Some jobs require the use of company credit cards and they want to ensure that the applicant will be able to both get approved for a credit card if needed and is also trustworthy in their use of that card.
  • To get utilities setup – yet another payment that a utility company wants made. You could be forced to provide a security deposit if you have bad credit.[9]

Credit score impact on a mortgage

Here’s a great example of why you should care about your credit score. Even if you came from the Dave Ramsey camp and don’t believe in credit cards, chances are you’ll have a mortgage at some point in your life. In the example below the different between a 760 credit score and a 639 credit score is $166/mo and $63,472 more paid in interest over the life of the loan! You pay $63,472 extra and get absolutely nothing in return. It’s purely a tax on a higher risk borrower because you’re more likely to default based on your credit score. [10]

Not maintaining top credit can cost you, a lot!

Tips for increasing your credit score:

  • Improving Length of Credit History: Stop closing accounts! This may seem counter intuitive but it can actually damage your credit score to close old accounts. Why? The length of your credit history will decrease if you close a very old account. Even if you don’t use a card anymore keep it open and put one or two charges a year on it to ensure the lender doesn’t close the account for inactivity. If the card has an annual fee see if you can do a product change.
  • Improving Payment History: Did you know that you don’t need to have a payment due to register an on-time payment with the credit bureau? The screenshot below is the payment history for a credit card that I use once a year to keep it active.
  • Improving Length of Credit History & Payment History: Add overdraft protection to your checking account. My overdraft protection shows up as a loan on my credit history. It’s the oldest thing on my credit report! That’s an easy way to build credit.
  • Improving Payment History: Make your payments FAR in advance of the bill. Why screw around waiting until the last minute and risk a problem that could give you a late payment? I pay my credit card balances in full every two weeks on the day that I get paid. Just because the credit card company gives you an extra month doesn’t mean you have to wait until a statement is issued to pay your card.
Paying those credit cards like clockwork, every two weeks.
  • Improving Payment History: Turn on autopay for your credit cards for the minimum payment due as a backup. Then you know you’ll never be late. You can still pay your cards on whatever schedule you want manually. I have autopay turned on even though I pay my cards every two weeks. Screenshot below showing the wide variety of autopay options.
  • Improve payment history: Have a system to ensure you never miss a payment. Create a payment schedule for bills so you know what bill is due on what day. I do this in YNAB by writing the due date next to each bill.

Improve Amounts Owed: This seems counter intuitive but open up another credit card. If you have a $3,000 balance on a $5,000 limit then you’re using 60% of your available credit. If you open another $5,000 limit card then your usage drops to 30% instantly. This is why credit card rewards can actually increase your credit score. Amount owed has a 30% impact on your credit score while new accounts have a 10% impact. The positive impact of reducing amounts owed with a new card outweighs the the temporary hit of a hard credit inquiry.

  • Improve Payment History: Open additional credit card accounts to reduce the impact of a late payment. More accounts = more payments which will more quickly lessen the impact of a missed payment. If you have a single card with 1 late payment in 1 year you have 11/12 or 92% on time payments. If you keep that same card for another year you have 23/24 on time payments or 96%. Still in the red. However, if you opened a second card for year 2 then you’d have 35/36 or 97% on time payments. If you opened a second and third card in year 2 you’d have 47/48 or 98% on time payments. You recover faster.
  • Figure out the ideal credit score range to be approved for credit before applying. Hard inquiries ding your credit score so do you homework first. For example, Nerdwallet.com gives you a recommended credit score range in order to be approved for a card.
Nerdwallet.com example credit card information.

Tips for establishing credit from scratch:

How do you build credit when nobody will extend you credit…because you have no credit history? It’s a cruel catch-22 situation. Here are some ideas to build a credit history if you’re just starting out:

  • Apply for an overdraft line of credit on your local bank checking account. This establishes a long term loan and if you have a savings account with cash in it this is low risk to the lender. Ask far a small amount as any amount will build credit.
  • Ask to be an authorized user on a relative or friends credit card. Even if they never hand you the physical credit card it’s still building your credit. That would be one way to make their risk zero (you don’t have a card to charge their account) and it’s still building your credit.
  • Get a secured credit card. These are credit cards where you put up cash as collateral. For example, they’ll make you provide $500 if your credit limit is $500 to ensure there’s no risk to the lender.

Action Steps:

  • Get a free copy of your credit report and credit score from a site like CreditKarma.com.
  • Review your credit report closely. Does anything look wrong?
  • If you have any errors contact the credit bureau (Transunion, Equifax, etc) and request that it’s fixed.
  • Take action from the tips section!
  • Take advantage if you have great credit with credit card rewards. I save $265/yr buying groceries with a card that requires excellent credit.
  • If you’ve increased your credit score drastically since opening up lines of credit call and ask them to reduce your APR. Refinance installment loans to lower rates.

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How have you improved your credit score? Did you learn something new? Did you take action and improve your score? Comment below!

Article Sources:

  1. FICOScore. Do I have more than one FICO score? https://www.ficoscore.com/faq. Accessed March 27th, 2021.
  2. FICOScore. YOUR CREDIT DECISIONS HAVE A DIRECT IMPACT ON YOUR SCORES https://www.ficoscore.com/education#CreditDecisions. Accessed March 27th, 2021.
  3. CreditKarma. Payment history: What it is, and why it matters to your credit. https://www.creditkarma.com/advice/i/payment-history-credit-report. Accessed March 27th, 2021.
  4. myFICO. What is Amounts Owed? https://www.myfico.com/credit-education/credit-scores/amount-of-debt. Accessed March 28th, 2021.
  5. myFICO. What is the Length of Your Credit History? https://www.myfico.com/credit-education/credit-scores/length-of-credit-history. Accessed March 28th, 2021.
  6. myFICO. What is New Credit? https://www.myfico.com/credit-education/credit-scores/new-credit. Accessed March 28th, 2021.
  7. Experian. Hard vs. Soft Inquiries on Your Credit Report. https://www.experian.com/blogs/ask-experian/credit-education/report-basics/hard-vs-soft-inquiries-on-your-credit-report/ Accessed March 28th, 2021.
  8. myFICO. What Does Credit Mix Mean? https://www.myfico.com/credit-education/credit-scores/credit-mix. Accessed March 28th, 2021.
  9. thebalance. People Who Check Your Credit https://www.thebalance.com/people-who-check-credit-report-960517. Accessed March 28th, 2021.
  10. myFICO Loan Savings Calculator. https://www.myfico.com/credit-education/calculators/loan-savings-calculator/ Accessed March 28th, 2021.
  11. FICOScore. What is a good FICO Score? https://www.ficoscore.com/faq. Accessed March 28th, 2021.
  12. VantageScore. VantageScore 3.0 White Paper. https://vantagescore.com/pdfs/VantageScore3-0_WhitePaper.pdf. Accessed March 29th, 2021
Categories
Income

How I Make $265 a Year Buying Groceries

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BLUF: Food is always a big spending category. Strategic use of the best credit cards can get you the most money back on groceries.

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I love food. I mean, who doesn’t it? It is a great part of life that you get to enjoy on a daily basis. What’s a little depressing though is that food, and largely groceries, are my second largest expense behind housing! I spent just short of $8,000 at grocery stores in 2020 between groceries, toiletries, cleaning supplies, prepared foods and alcohol. That’s for two people and spending about half of it at a local discount grocer called Aldi’s.

I’m always looking for ways to save money or get money back which is why I was blown away when I found this cash back option. I also found myself feeling bad for the people around me paying in cash, check and other credit cards that are just giving free money away. It seems weird to approach strangers at the store about saving money so I’ll do it via blog instead.

Show me the money

The American Express Blue Cash Preferred gives you 6% (!!!) cash back on the first $6,000 you buy in groceries at grocery stores. Every. Single. Year. That’s 6%, everyday, at normal grocery stories. It’s not some special rate that only works for 3 months and then rotates to another category. 6% cash back x $6,000 in a year is $360 back in your pocket. Score.

There is a catch though. And before I tell you please promise to hear me out. It has a $95 annual fee. The horror! Many people see an annual fee and it’s a non-starter for them. They see that they have to pay $95 every year to have a credit card and they’re out. It’s important, though, to keep an open mind in life and not dismiss any idea before you do the math and see if it actually makes sense.

To the math, smart consumer!

In calculating the true value of a credit card I think you must include any fees into the equation to be fair. In this case, the $95 annual fee. In other words, the true value in this card is $6,000 * 6% = $360 – $95 = $265 a year for groceries. You could keep spending more but it drops to 1% so you should be putting that on another card.

But how does that compare to a 2%, no annual fee card like the Citi Double Cash which I also love and carry in my wallet? Let’s dust off our high school algebra. The equation 0.06x – 95 = 0.02x, solving for x, will tell me the exact amount I need to spend in grocery stores in a year (x) for these two cards to give the same total cash back.

  • Solving for X:
  • 0.06x-95 = 0.02x
  • 0.06x = 0.02x + 95 – Add 95 to both sides
  • 0.06x-0.02x = 95 – Substract both sides by 0.02x
  • 0.04x = 95
  • x = 95/0.04
  • x = $2,375 at grocery stores

We can check our work easily.

  • $2,375 * 0.02 (2%) = $47.50 for the Double Cash card.
  • ($2,375 * 0.06) – $95 = $142.50 – $95 = $47.50 for the Blue Cash Preferred

$2,375 a year at a grocery story is only $198/mo. Pretty easy to hit in just groceries, let alone buying toiletries, alcohol and prepared foods there. Anything spent more than that and the Blue Cash Preferred is the easy winner. Spending $500/mo on average for even my family of two is no problem to hit the $6,000 max value. Worst case I could always buy gift cards there which is conveniently at the end of the year at Christmas time.

But wait, there’s more

The card would be worth it for me if I just stopped there at groceries. You also get 6% on streaming services and 3% on gas, tolls and ride share? Here’s a little snip from my account showing those sweet sweet cash back numbers.

The usually have some kind of sign up bonus but right now it’s an even sweeter deal. A nice sign up bonus AND the first year annual fee waived.

Current offer at the time of writing in March 2021.

Action Steps:

  1. Review your budget and spending history. How much do you spend in grocery store purchases in a year?
  2. Take a look at your current credit cards and how much cash or other rewards you’re getting from them. Are you maximizing your rewards?
  3. If not, consider opening the American Express Blue Cash Preferred. The the sign up bonus it’s a no risk option to try.

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Join the conversation. Comment below if you have this card! Comment below if you have another card that you think is better!

Categories
General FI

Emergency Fund: Part 2 – Where to store it?

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BLUF: There are many options for where to store an emergency fund. The question is actually how you want to finance an emergency. Saving money in a bank is a common option but selling assets and financing an emergency with credit are options too. Most emergency fund plans include a combination of more than one of these options.

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The traditional thinking on an emergency fund is 3-6 months stuffed into a savings account. My part 1 article challenged you to figure out exactly what YOU need to cover a loss of income, not just use a rule of thumb. Now that you’ve done that you have a number in mind that you need. You have done that, right? But where does that $10,000 come from? Do you save it and if so, where? Do you invest the money and sell assets? Do you finance it with credit cards or a HELOC?

One thing that’s so interesting about personal finance is that there are a million different options to solve the same problem. Our upbringing, life experiences and knowledge form our risk tolerance, biases and how we think about money choices. This is also true when it comes to the idea of an emergency fund.

The purpose of this article is to make you aware of the different options available to you and some pros and cons of each. The solution for most people is not any one bucket listed here but a combination of multiple options in a tiered approach.

Three types of approaches:

You’ll notice three groups of options in this article for financing an emergency:

  1. Withdraw Cash – These methods rely on saving cash pre-emergency in a location and then withdrawing the money when needed.
  2. Sell Assets – These methods rely on selling investments that you’ve previous acquired, turning them into cash and withdrawing the money when needed.
  3. Finance the Emergency – These options mean taking on debt to finance the emergency.

Keeping Perspective:

One thing that is important to keep in mind when thinking about planning to cover an a major loss of income emergency is that these should be tail events. A tail event, sometimes called a “black swan”, meaning a very low probability of occurring so they happen infrequently.

How often during your parents working life did they lose a job or income for an extended period of time? Hopefully only once or twice in their working life. Maybe never. It’s important to keep in mind that while it’s important to have a plan, we’re talking about events that may never happen. If they do happen, it might only happen every 10, 15, 20 years or more in a 40-45 year tadeonal working “lifetime”. In other words, 1-3 times in a lifetime.

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Evaluating each option:

In evaluating each option I’ll discuss four different characteristics:

Liquidity – how easily and quickly can that asset or money get into your hands as cash to use to fund your emergency.

Risk – what is the risk of the money not being there when you need it at the amount you need.

Costs – what does it cost you to use this option to fund an emergency. This includes fees and tax implications.

Opportunity Cost – how much are you giving up in growth to put your money here instead of a retirement investment option. For example, if an index fund returns 7% a year on average then keeping money in a low yield (.01%) savings account has a high opportunity cost.

Options to Cover an Emergency

Withdraw the money in a Low Yield Bank Account (Checking/Savings)

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  • What is this option?
    • A traditional account often offered at either a local bank or a national bank with local branches. Very low interest paid out against the money deposited.
  • Characteristics:
    • High liquidity – Often at a local bank with easy ATM access. You can get the money very fast.
    • Low risk – FDIC insured so very low risk of it not being there when you need it and no risk of it’s face value going down.
    • Low cost – free ATM and bank account withdrawals.
    • High opportunity cost – Earning almost no interest so it’s losing spending power over time due to inflation.

Withdraw from a High Yield Saving Account (HYSA)

crop female entrepreneur sitting sitting at desk and working on computer
Photo by Anna Shvets on Pexels.com
  • What is this option?
    • A bank account that offer 5-10x+ interest than a traditionally bank account. These are usually in an online only bank although some physical banks offer HYSA’s. I personally use Marcus by Goldman Sachs and have been happy with the service. You get an introductory period special APR if you sign up with the link.
  • Characteristics:
    • High liquidity – I’d still call this high although not as high as a local bank. Some HYSA’s have no ATM option so you need to do an online transfer taking 1-3 business days to get it to a local account.
    • Low risk – FDIC insured so very low risk of it not being there when you need it and no risk of it’s face value going down.
    • Low cost – free ATM and bank account withdrawals.
    • High opportunity cost – This is highly dependent on interest rates. At the time of writing the rates are 0.5% for many accounts making you lose to inflation.

Sell Assets from a Brokerage Account

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  • What is this option?
    • Selling stocks, bonds, mutual funds or ETFs from a brokerage account at the current market value. Then transferring the funds to a local bank account.
  • Characteristics
    • Medium liquidity – You need to sell the asset which can only happen during market hours. After the asset is sold you need to wait for funds to be transferred to a local bank. If you need to transfer a large percentage of the total account value you may have to wait for the transaction to settle before being able to withdraw the full amount.
    • Medium risk – Stocks increase in value on average of 7-8% / year. If you happen to be unlucky and an emergency hits during a recession or major correction you could be forced to sell at depressed prices. However, you are likely saving much more than needed for just an emergency so having enough should not be an issue for all but the largest emergencies.
    • Medium cost – You will likely be selling assets that have capital gains associated with them. This means paying short term or long term capital gains on the sold assets come tax time.
    • Low opportunity cost – Major emergencies happen infrequently on average so that money can grow with the market when it isn’t needed.

Sell Assets from a Roth IRA

  • What is this option?
    • Selling stocks, bonds, mutual funds or ETFs from a Roth IRA account at the current market value. Then transferring the funds to a local bank account. Unlike the brokerage account no taxes are due but you cannot withdraw more than your contribution amount penalty free if you’re less than 59.5 years old.
  • Characteristics:
    • Medium liquidity – You need to sell the asset which can only happen during market hours. After the asset is sold you need to wait for funds to be transferred to a local bank. If you need to transfer a large percentage of the total account value you may have to wait for the transaction to settle before being able to withdraw the full amount.
    • Medium risk – Stocks increase in value on average of 7-8% / year. If you happen to be unlucky and an emergency hits during a recession or major correction you could be forced to sell at depressed prices. However, you are likely saving much more than needed for just an emergency so having enough should not be an issue for all but the largest emergencies.
    • Low cost – No capital gains taxes to pay in a Roth account.
    • Medium opportunity cost – Your money is growing in the Roth when invested but you have a limited amount you can contribute to the account annually. If you withdraw it for an emergency it may take many years to replace that money.

Sell Real Estate

white and brown concrete bungalow under clear blue sky
Photo by Pixabay on Pexels.com
  • What is this option?
    • Selling an investment property or private residence to pay for an emergency. Probably an unlikely occurrence for most unless an emergency with a massive financial cost occurs.
  • Characteristics:
    • Low liquidity – This is about as bad as it gets. Likely 1-3+ months to go from listing the property to having cash in your account.
    • High risk – Not because the property value may drop necessarily but in an emergency you’ll likely need to price it low for a quick sale.
    • High cost – You may not have to pay taxes on the gains if a primary residence but there’s a high transaction cost to selling a home. 6% to pay both agents typically plus all closing costs along with any requests from the buyer. If it’s an investment property then add on capital gains on top of that.
    • Low-Medium opportunity cost – Medium if this selling a primary residence in places with low property appreciation. Low if your area has high appreciation or if this is a good cash flowing investment property.

Sell Assets from a Pre-Tax Retirement Account

  • What is this option?
    • Selling stocks, bonds, mutual funds or ETFs from a Pre-Tax retirement account (401k, 403b, 457) account at the current market value. Then transferring the funds to a local bank account. Like the Roth no taxes are due on the sale of assets they are taxed as income when you withdraw the money. Additionally, there are usually penalties if you’re under 59.5 years old unless the emergency qualifies as a special situation where the penalty is waived.
  • Characteristics:
    • Low liquidity – You need to sell the asset which can only happen during market hours. Retirement accounts are not intended to have money removed before retirement so there is usually paperwork and a slow process involved in doing it unless you’re going to take a loan.
    • Medium risk – Stocks increase in value on average of 7-8% / year. If you happen to be unlucky and an emergency hits during a recession or major correction you could be forced to sell at depressed prices. However, you are likely saving much more than needed for just an emergency so having enough should not be an issue for all but the largest emergencies.
    • High cost – The money is taxed as ordinary income when removed and is usually penalized on top of that.
    • Low opportunity cost – Your money is growing in the account when invested but you have a limited amount you can contribute to the account annually. If you withdraw it for an emergency it may take many years to replace that money.

Finance with credit cards

black payment terminal
Photo by energepic.com on Pexels.com
  • What is this option?
    • Living off of credit cards if income is lost or covering a major expense with them.
  • Characteristics:
    • High liquidity – Assuming you have cards open already it’s very quick to pay for expenses.
    • Medium risk – Depending on your credit you might not be able to cover a sizable emergency.
    • Medium cost – Interest will be owed if you can’t payoff the balance in one cycle. If you’ve lost a job this could take quite a while to pay back. Additionally, some expenses like rent and mortgage can’t be paid with a credit card unless a 3rd party service is used. These usually charge a 2+% fee on each transaction.
    • Low opportunity cost – You don’t tie up any money so you can invest any available cash.

Finance with a HELOC

  • What is this option?
    • Living off your Home Equity Line Of Credit (HELOC) in a loss of income situation or financing an emergency expense with it.
  • Characteristics:
    • High liquidity – Assuming the HELOC is already open. If not then this would be low as this usually takes some time to close.
    • Low risk – 2008 showed that credit giveth, credit taketh away. The bank can freeze credit if they really want to and they did in 2008. If you plan on waiting for an emergency to open a HELOC then timing adds to the risk.
    • Medium cost – Interest is low but there is usually a non-trivial cost to setting up a HELOC in the first place. If you’re using the HELOC for other purposes you may call this cost low.
    • Low opportunity cost – You don’t tie up any money so you can invest any available cash.

My approach:

I use a combination of 3 different accounts as my plan, but I have other accounts available to me if necessary:

  1. ~$1,000-2,000 in local bank funds. Not earning much but highly liquid.
  2. $3,000 – in an online HYSA. $3,000 is my true emergency fund but our travel sinking fund is also stored in a HYSA. So, there’s other money sitting there that could be used in an emergency.
  3. The rest – brokerage account. Still fairly liquid and my money is invested to stay growing when no emergency occurs.

I chose these options because it gives me a combination of accounts where I have quick access to money for small things but then the larger emergencies that are infrequent can use accounts where my money is growing.

Actions:

  1. Review the part 1 article and calculate how much of an emergency fund you’d need.
  2. Review the options on this page. You should at least one option that is high liquidity to handle small to medium size emergencies.
  3. If you have a higher risk tolerance, consider utilizing an option with a low opportunity cost to fund very large large emergency.
  4. Write down your plan! Think through your plan if your large emergency happens to get cash in your hands. Adjust the plan if necessary.
  5. Relax. There is no perfect answer here. The fact that you have a plan makes you far ahead of many other people.

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What is your plan to cover an emergency? Comment below!

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