EMERGENCY MONEY is dead money—and it’s rarely looked more dead.
Just as we shouldn’t carry more insurance coverage than we really need, we shouldn’t hold more emergency cash than necessary. Why not? Excessive money spent on insurance and kept in our emergency reserve will likely come with a hefty opportunity cost. Indeed, thanks to the double whammy of inflation and taxes, our cash reserve will slowly depreciate, and that’s especially true given today’s rock-bottom interest rates.
What to do? Conventional wisdom says you should have a cash reserve equal to three to six months of living expenses. My advice: Figure out if you can hold far less—by pondering both your living costs and alternative sources of cash. To that end, consider these eight steps:
1. Calculate your fixed costs. You might have to cut spending temporarily if, say, you need all available cash to pay for a new furnace, roof or car. More worrisome, you might find yourself without a paycheck because you get laid off or ill-health prevents you from working.
In these scenarios, you’ll likely want to cut out much or all discretionary spending, so your only expenses are your fixed living costs—things like mortgage or rent, car payments, utilities, groceries and insurance premiums. How much do these run each month and, in a financial pinch, are there any items you can eliminate? Figuring this out is a crucial first step in developing your emergency plan.
2. Recast your mortgage. For most folks, their biggest fixed living cost is housing. Is there any way to reduce this expense? I’m a fan of paying down mortgage debt as an alternative to buying bonds. Planning to make a large onetime extra-principal payment of perhaps $5,000 or $10,000 on a fixed-rate loan? Consider coupling it with a mortgage recasting.
Not all mortgages can be recast. But if your lender allows it, you’ll need to cough up not just a large extra-principal payment, but also a fee of up to $500. In return, the mortgage company will reduce your monthly payment to reflect your new lower principal balance, while keeping the loan’s term and interest rate the same. Result: Going forward, you’ll have lower fixed living costs—and more financial breathing room if you get hit with a financial emergency.
I wish I’d been aware of this option when I had a mortgage. I made regular extra-principal payments for many years. A recasting would have sharply reduced my required monthly mortgage payments, leaving me in much better financial shape if I’d lost my job.
3. Tap home equity. Some folks argue against making extra-principal payments on a mortgage, noting that—in a financial emergency—you’d be better off having the cash sitting in a savings account. It’s a reasonable argument. But you can sidestep the problem by setting up a home-equity line of credit, or HELOC, which would allow you to tap into your home’s value. Just be sure to set up the credit line while you’re still employed and hence still look attractive to lenders.
What if you’re already retired? Instead of a HELOC, you could arrange a standby reverse mortgage. The idea is to establish a credit line that grows over time, which you might then use later in retirement if you start to deplete your nest egg. You could also use the credit line to cover financial emergencies, especially if it seems like a bad time to cash in stocks and bonds. The strategy has been endorsed by experts, though—I must confess—I’m leery of the steep fees involved.
4. Stash money in a Roth IRA. If you want your dollars to do double duty, consider making regular annual contributions to a Roth IRA. Suppose you put $6,000 a year in a Roth for the next four years. Ideally, you’d leave the $24,000 to continue growing tax-free. But if calamity strikes, your retirement fund could become your emergency fund—and you could withdraw that $24,000. Provided you don’t touch your Roth IRA’s investment earnings, there’d be no taxes or penalties owed.
5. Fund a health savings account. Like a Roth IRA, a health savings account (HSA) can do double duty. The strategy: Buy a qualifying high-deductible health insurance policy and fund a companion HSA. Thereafter, when you incur medical expenses, pay the costs out of pocket but hang on to the receipts. If you’re hit with a financial emergency, you can use those old receipts to make tax-free withdrawals from your HSA. What if there’s no need to draw on the account? You might leave your HSA to grow tax-free and then use it to pay medical expenses in retirement.
6. Tap your 401(k). If you lose your job, a 401(k) loan wouldn’t be an option. In fact, if you leave your employer, these loans must typically be repaid right away, or you’ll face income taxes and penalties. Still, a 401(k) loan could be useful in other financial emergencies. Keep in mind that these loans aren’t really loans. Instead, the money you receive reduces your 401(k) account balance—and the true cost is the investment gains that the money no longer earns.
7. Borrow on margin. I’m not a fan of margin loans, which involve borrowing against the value of a taxable brokerage account. But if you restrict the loan to, say, 20% of your account’s balance, the risk involved is modest. Yes, if you take out a margin loan, you’ll have to pay interest. But that occasional cost could be a small price to pay if it allows you to sit on less cash.
8. Take out a life insurance loan. As with margin loans, I’m no fan of cash-value life insurance. But all too many folks end up with these policies when they’d be far better off with low-cost term insurance. In fact, cash-value life insurance accounted for 59% of the life insurance policies sold to individuals in 2019—a statistic I find shocking.
Got one of these turkeys? If you find yourself in a financial pinch, you might put it to good use by taking out a life insurance loan. But—as with 401(k) and margin loans—be sure to pay off any life insurance loans as quickly as possible.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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Of all of these, I’ve found the heloc to be the most flexible. In a true emergency, we’d fill up credit cards and utilize the Heloc… but we still hold cash as well, and we’d use that first.
My key worry is that Helocs can be frozen, so in a widespread economic emergency you may not even get use of it.
I really hate holding cash, but it’s better than forced liquidation. The truly difficult part is deciding how much to hold. In an uncertain world, it’s good to hedge, but not too much.
I learned about mortgage recasting from this site, and I’m really glad I did. We’re still working, are maxing out our retirement accounts, and have no debt other than our mortgage. We’re both getting raises this summer and had discussed putting them towards extra principal payments, but now I think instead I’m going to put that money into an earmarked savings account, build up a balance, and do a recast sometime in the next few years before we retire. Our interest rate is great because we refinanced in 2020, so just lowering the balance would be perfect. I also love the idea of NOT tying up the money in the house until we’re ready to do the recast—keeps us flexible in case we need or want to do something else with it in the meantime.
I generally keep my emergency cash reserves to a minimum. However, given the richly valued investment markets for just about everything, it might be advisable to hold more cash than usual as an option on future investment opportunities.
I treated my HELOC as my emergency cash reserve for about 30 years. Only a couple of times in that period did I have to tap it for a genuine emergency, and I paid those balances down over time after the emergencies passed. But I am very glad that I did not have six months’ worth of living expenses tied up in an “emergency cash reserve” for all 30 years. I found the opportunity cost too high.
Re 401k – I understand that, if I lose my job AND I’m over 55, I am able to access my 401k balance without penalty, as long as I leave it in the employers plan. My plan allows a PCRA, and I’ve been expecting to use this as my emergency fund, if necessary. Is this an accurate understanding on my part?
Yes, at age 55 or older, you should be able to make withdrawals without penalty from a 401(k), provided you’ve left your employer:
This week’s topic reminds me of Warren Buffett’s line, “Cash is like oxygen – it’s taken for granted until there’s not enough of it.” Yes, holding cash has an opportunity cost, presently, courtesy of the Fed continuing its pocket-picking of savers, but cutting spending, going into HELOC debt, encumbering one’s 401k and life insurance death benefit, and having to worry about Roth IRA and HSA withdrawal rules also carry costs. I think I’ll stick with keeping my oxygen tank full.
Would another possible strategy to build and preserve a reserve be to build your leave balance and maintain it at some minimum? I recognize that this option is not available for everyone and perhaps it depends on what one is most concerned about having the emergency funds cover. What came to my mind was loss of job or extended illness. Maintaining a leave balance of some minimum hours would seem to cover both and leave cash available for investment. Further, leave earned in previous years is payable at today’s dollars so in a sense it increases in value.
I think your big point is not so much where to get emergency money, but rather that in an emergency you may have recourse in addition to any cash balances. I no longer keep an emergency fund as I once did for exactly this reason.
My shortest term option is to pay a day or two of margin interest in order to access cash while I wait for securities to clear (2 business days.) As long as financial markets are orderly, this costs about $5 for $10,000. I only use margin to cover such short term needs, not to speculate on securities.
Longer term, I can sell securities, and here I benefit by owning some outside retirement accounts, where I also pay lower long term capital gains tax rates.
If I found myself in an extended draw down of assets, eventually I would end up tapping roth accounts. There I would benefit from the more flexible rules for withdrawals compared to traditional accounts, another reason for moving money to roth options as soon as possible.
I don’t own cash value insurance any more because I don’t need it, but when I did I had run the numbers that told me that I was saving money if I needed insurance for more than about 15 years, and I am that kind of long term investor. Some people confuse renewable term policies with fixed rate policies, but I’m sure you’re not one, and so you must have your own reasons for avoiding cash value policies for long term needs. Other people forget that when you no longer need insurance, you are wasting your money whenever you keep an insurance policy, as anyone selling you one reasonably expects to make a profit by doing so. And of course, no insurance company will remind you of this.
One thing I don’t do is save receipts for reimbursement from my HSA. My understanding is that the IRS would look more closely at large withdrawals and they will be harder to document as time passes. Therefore I take the benefit of tax-free medical expenses each year, knowing that three years later I will have a lowered burden of keeping documentation. Of course, it is also true that medical emergencies are one class of contingencies, and having an HSA directly addresses that as well. Fidelity offers a zero-fee HSA that can be directly invested, and HSA balances can be transferred between custodians without penalty.
This was a timely post. I was in the process of deciding whether to go with a first-lien or second-lien HELOC (.25% upcharge). I wasn’t too keen on giving up the low fixed rate on our primary mortgage. I recently made a large payment to obtain 80% equity within my home, and the best rate on the HELOC. A mortgage recast based on our large payment will allow our family to reduce our fixed payment by 50%, and reducing the interest rate risk; if inflation rears it’s ugly head. Thanks for sharing as always.
Thank you for posting as this subject has been on my mind. I am in the process of recasting my mortgage and on the lender recast request form it states the fee is not charged for the following states: AL, AZ, CA, IA, KS, MA, MS, MT, NC, PA, TX, VT and WV.
As you say there is suspicion about reverse mortgages which is illustrated by the fact that only about 3% of seniors utilize reverse mortgages due in part to the fees(average around 3 or 4%). On the other side is that the funds utilized by someone via a reverse mortgage do not have to be paid back until the property is sold when the eligible mortgage holders have left the property. This is a non-Recourse loan which means the amount owed at the disposal of property is limited to the value of the property at disposal. This is unlike a HELOC where the money has to be paid back right away. If you have a HELOC you have to hope that there isn’t another 2008 financial collapse which could cause your lender to take back the HELOC. Someone with a reverse mortgage on a property assessed at $100K would have access to a little over $50-55K less fees. Unused balances are currently earning about 3%(of course affected by overall level of rates in the US). Probably over half of the retiree population has assets in terms of net worth well below the $175-200K range. That population will probably double over the period from the 2010 census to 2050 according to Census Bureau(from 10% in 2010 to 20% of US population in 2050). Yes, there is a cost, but it is a product that more than 3% of the retiree population could definitely use. An added benefit is that there is a mandatory financial consultation prior to allowing someone to engage in this product. Having a RM could easily solve the problem you are discussing here.
Recasting a mortgage must be the best kept secret in the mortgage industry. This is the first time I’ve ever heard of it.
Here is a more in-depth look at mortgage recasting:
I agree — I heard of recasting for the first time last year.
“What if you’re already retired? Instead of a HELOC, you could arrange a standby reverse mortgage.”
While these have had a bad rep for years I encourage everyone contemplating a reverse mortgage to read Dr. Wade Pfau’s “Reverse Mortgages” (2nd edition).