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.
Note, this article includes affiliate links where the blog receives a benefit if the link is used. If you’d like to support the blog then use a link.
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:
- Withdraw Cash – These methods rely on saving cash pre-emergency in a location and then withdrawing the money when needed.
- Sell Assets – These methods rely on selling investments that you’ve previous acquired, turning them into cash and withdrawing the money when needed.
- 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.
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)
- 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)
- 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
- 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
- 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
- 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:
- ~$1,000-2,000 in local bank funds. Not earning much but highly liquid.
- $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.
- 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:
- Review the part 1 article and calculate how much of an emergency fund you’d need.
- Review the options on this page. You should at least one option that is high liquidity to handle small to medium size emergencies.
- If you have a higher risk tolerance, consider utilizing an option with a low opportunity cost to fund very large large emergency.
- Write down your plan! Think through your plan if your large emergency happens to get cash in your hands. Adjust the plan if necessary.
- Relax. There is no perfect answer here. The fact that you have a plan makes you far ahead of many other people.
Like the content? Click here to subscribe to the e-mail list and have the articles delivered to your inbox.
What is your plan to cover an emergency? Comment below!
