The following is a guest post from James who is documenting his path to early retirement over at Free in Ten Years (freeintenyears.com). He aspires to live on 25% of his income and invest the rest by being extremely frugal and avoiding typical consumer traps. He plans on being free from work in less than ten years, before the age of 38. You can follow him on twitter (@freeintenyears).
Having an emergency fund is a fundamental part of having healthy finances. The reasons are obvious – it’s a buffer against unemployment, it’s an insurance policy for unplanned expenses, and it’s peace of mind. For someone like me who is aiming for an early retirement an emergency fund is crucial.
The problem with typical emergency funds
Most emergency fund recommendations are to have six months to a year’s worth of expenses in a highly liquid account so that it can be accessed at a moments notice in case of an emergency. It’s important to note that this is not the same as a year’s worth of income – it doesn’t include any savings you might already be making.
It might be controversial, but having six months of expenses in a savings account is probably too conservative for the average person in my opinion. Lets assume that six months of expenses is $25,000 for the purposes of this example.
In a high interest savings account in the US, that money would earn approximately $250. Typically the emergency fund wouldn’t be used very frequently because periods of unemployment are (hopefully!) quite rare, as are large emergencies.
Using your mortgage to house your emergency fund
If you have a mortgage with an offset account or the ability to redraw without paying a fee, then you should consider putting a large portion of your emergency fund into the mortgage. My recommendation to someone who already had their $25,000 emergency fund in place would be to put approximately $20,000 into the mortgage and leave only $5,000 in a high-interest savings account.
This would mean that in the case of a large emergency, the bulk of the money might be one or two days slower to arrive, but aside from that, all other factors are positive. For example,
Typical emergency fund:
- $25,000 at 1% = $20 per month.
Mortgage-based emergency fund:
- $20,000 in the mortgage saving 4% = $66
- $5,000 at 1% = $4
Net gain: +$50 per month.
It is very important to note that this will only work if you can redraw on your mortgage without paying a penalty. Not all loans allow this – you should check with your mortgage provider before you put your emergency fund in there, because you might not be able to get it back out if you need it!
You should also check how long it takes for the bank to process a request for a redraw and what sort of process it is. A normal bank will take only a couple of days, but it’s worth knowing this before you start the process. The point of keeping $5,000 out of the mortgage is to hold you over until the balance arrives in your account.
In the case of unemployment $5,000 is likely to represent quite a significant period of living expenses and so should last you easily until the $20,000 arrives.
Consider pairing with a credit card
This strategy works particularly well with a credit card that has no annual fee that you put aside simply to be used until the redraw is processed. When the redraw arrives in your account, the credit card can be fully paid off – thus avoiding any interest charges.
Is your emergency fund too conservative?
Consider whether your emergency fund sitting around earning 1% or less is too conservative for you. Given the inflation rate at the moment, your emergency fund is actually losing value through inflation if you are earning less than about 3% on your savings account.
Every situation is unique and there may well be situation where having six months of living expenses in a savings account is necessary, but for most I suspect the normal emergency fund recommendation will see people unnecessarily lose money. For me, I only keep one month’s worth of expenses in a savings account and the rest is in the mortgage.
If you don’t have a mortgage, your emergency fund can also be put into an investment vehicle like an index fund, but again – check how long it takes to process a payment from your particular financial institution.
If you don’t yet have an emergency fund or are working towards one, rather than contribute to a savings account, just make extra contributions to your mortgage until you have your emergency fund fully in place. Just keep track of your additional contributions so you know how big your emergency fund is.
Consider whether your emergency fund is actually providing you with the maximum benefit – if you work in a stable job, have health insurance and haven’t used your emergency fund in living memory – perhaps you should consider whether it’s really the best thing for you to have so much cash sitting around losing value thanks to inflation.