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
- =$70
Net gain: +$50 per month.
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.
Interesting strategy. To simplify, why not just pay your entire emergency fund on the balance of your mortgage and have a low-interest line of credit (HELOC) against your house, for that amount, and allocate that for emergency use only? It’s kind of almost the same thing, isn’t it? You would have a ton of upfront savings in interest saved on the mortgage, and would only have interest expenses on the HELOC, IF you needed to use it. You could even use a low-interest credit card instead of a HELOC, which I think would be better because it would be unsecured (if you qualify).
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A HELOC sounds very similar, but unfortunately don’t exist where I am so I hadn’t considered it. I’ll have to look into it and see if something similar is available here. It sounds like the outcome is the same.
A good idea for you guys in the US who don’t have access to the sort of redraw accounts I’m referring to.
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Matthew an interesting simplification and something people can do. However, I am generally against prepaying a mortgage if you can earn more returns outside. Peer to peer lending, dividends stocks, bonds are some places where you can make some returns on your money. Yes you do take additional risk for additional returns, so diversify your savings.
Also making contribution to Roth IRA which can be accessed after five years since the account has been open is a good way to invest for retirement but still have access to your money
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Really interesting strategy here and something I have thought about. One thing I would add is that if you get a Health Savings Account you can move some of your emergency fund there, since all your health-related “emergencies” can be paid out of this account that gives you huge tax advantages.
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I’ll have to ask my brother about the tax implications as he is the tax expert in our family. I have no idea
I think most emergency funds projections are too conservative, but some people need that safety to sleep at night. If you are more adventurous with your money, you can take even more risks and invest in stocks, shares, other real estate… with a little change, should and emergency arise, that you would have to cash out at a loss.
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I guess it depends on your situation in life and how much of a risk taker you are. I know plenty of people who would rather have their money working for them than sitting in a bank account.
You just have to be sure you can get access to it when required.
Never heard of this before but is does seem like it could work based on how you outlined it. I was thinking way not just get a HELOC or line of credit on your home but after working in the industry I remember how quickly homes were devalued and the lines of credit were gone. I remember one woman have a 500k line it getting cut to 50k. Not sure if I would take my chances on that. Maybe do have in the mortgage account and rest in laddered cds.
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It’s a similar concept to the HELOC, but instead of credit, you are using your own money. I couldn’t fathom having a loan without an offset account now that i’ve had one.
This is an interesting concept, but I never knew you could do this with a mortgage. I’d be curious if the interest rates differ on this type of loan. We had a recent refinance, so I don’t see changing our loan type for this purpose, but we do intend to start agressively paying it off. We have a HELOC and quite a bit of equity in the house, so this might be a good alternative to having a large amount in liquid savings. Something to consider.
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I actually have an offset account on my mortgage but it doesn’t have a waiting period on withdraws. The interest rate is the same as a mortgage without an offset account, it’s just a place to park your money so you pay less interest on your loan.
I’ll explain – The Offset account is pretty much like any other type of savings account, the main difference is that rather than gaining interest each month, it is negating interest on your mortgage. We have almost our entire amount of money tied up in our offset account as it’s accessible at call in an instant.
I agree with Pauline and try not to have more than a small liquid portion sitting stagnant in a near-zero interest account. That is a sure way to erode the purchasing power of your hard-earned dollars that you’ve traded your time and life energy for! With this type of low-interest environment, people need to become more creative with how they may prudently handle their finances, unfortunately.
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I think it is different for you guys being over in the US. Interest rates are ridiculously low so you have a constant battle with inflation eroding your capital.
In Australia interest rates on mortgages are between 5 and 6% PA. So it’s a very different scenario.
James I’ve never heard of this type of mortgage. I will have to look into it. I was thinking of placing 25% of my emergency fund in a standard high interest account and using the rest in P2P lending. But will definitely see if they offer this in my area.
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I wouldn’t advise putting an emergency fund in P2P lending. It’s an extremely risky investment that as I understand, can be difficult to get your money out of quickly. It’s sort of the opposite of the best emergency fund vehicle in my opinion.
A mortgage is great, because it’s practically risk free, and in this case, really quite liquid.
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James, this is very creative, but I’m afraid it misses the point of the Emergency Fund. Your Emergency Fund is not an investment; its intended to be a layer of security in case something terrible comes up and you need the money fast. While some mortgages may allow this (mine doesn’t), I don’t think most people will want to mess around with this process if they are dealing with a true emergency. However, I will second you that 6 months of savings is a lot to leave on the table doing nothing. I actually prefer to have about 3 months, so this would give you 3 remaining months to use in semi-liquid funds.
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Hi MMD,
I don’t think it misses the point at all. I understand the purpose of an emergency fund – there are very few scenarios where you would need all three months worth of expenses in less that one day. Can you explain to me a scenario where you’d need three months worth of expenses instantly?
The reason three to six months worth are recommended is normally because of a period of unemployment lasting that long would allow for time to find a new job. In this scenario you have many weeks to get the money out of semi-liquid investments.
The beauty of a mortgage you can redraw from is that the funds are available as fast as a normal bank transfer. If you have your emergency fund in an ING DIRECT account – it’s going to take just as long to get to you. The small delay that exists (a few business days) can be covered by a no annual fee credit card.
I know it’s not an investment, but there is no reason it can’t be. For the 99% of the time we are living in the non-emergency zone – that much money should be working hard for us!
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This is definitely an interesting strategy for an emergency fund and one that many have been talking about before. I like the idea and you are maximizing your money. I wish I had the ability to redraw on my mortgage, but I didn’t think about that when I got it (first time home buyer). There are a lot of things I will do differently when I purchase another home. Thanks for the tip.
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I think we would all have done something different after your first home. Sometimes you just have to learn first hand though so you can do it better the next time.
There is something in Canada called the Manulife one where everything is put into one account and you can draw on the money. There is much more to this type of mortgage/account that I can’t get into but we opted not to go with it as we knew our mortgage would be paid with-in a few years. Our Emergency Savings is pretty high but with good reason. We didn’t move the money anywhere simply because we want to get rid of the mortgage and sure we could have made money but we didn’t and we’re ok with that. We’re happy it was making what it did and that we can now live mortgage and debt free. We can get the HELOC but we likely will just save our money now to build up our 6 months of Emergency Savings and invest the rest in real estate, investments and other ventures. Interesting post. Mr.CBB
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Thanks for your comments Mr.CBB
It’s always interesting to hear about the different options available in other countries.
I agree with using the mortgage as an emergency fund, and I had plans similar to that: A few years ago I opened a $40,000 HELOC at a credit union. I applied what I had in my emergency fund to the mortgage, thereby reducing the length of the mortgage by seven years.
But my motives were different. It was (1) to transfer the mortgage balance when hubby retired and have a smaller payment without incurring closing costs, or (2) to cover funeral expense since we do not have life insurance. But an emergency occurred – I lost my job after his income decreased. I transferred the mortgage balance to the HELOC. Now jobless, we are still able to pay the mortgage/HELOC (but not escrowing the RE taxes) until I am employed again. Currently the interest rate is 4.1%.
I’m really glad you managed to find work again Ellen. There is not much worse than having a mortgage and then losing your job and having no money to pay back the loan.
Thanks for taking the time to comment – I appreciate the effort