Should you take out a loan to fund an Emergency Fund?

Disclosure, this isn’t a fake reader question, I was just trying to figure out a title that helped people look at things a bit differently.. Let’s tackle the mighty emergency fund again.  Probably the most misunderstood financial tool, sadly by financial professionals too. Let’s clear up a few things before going on, by defining an emergency fund, according to yours truly:

1. An emergency fund is store of highly liquid funds that are in place to protect total wealth in the event of a financial emergency.
2. An emergency fund should never be calculated as a derivative of salary or income.  It is intended to cover expenses when they cannot.  There is no proven correlation between income and expenses so relying on the former is incorrect.
3. An emergency fund is not needed by everyone all the time, but most people need one at certain times.  It should have elasticity tied to fluctuations in risk.

To the title of this post, should you take out a loan to get one? Most advisors would say ‘heck no!’ But they would then go on to advise that you save up 3-6 months of salary (repeat after me IT IS EXPENSES YOU NEED TO COVER, salary is irrelevant) as a top priority.  The savviest of these advisors would then go on to recommend an online account like Ally that offers 0.8%-1% APR.

Let’s take a look at this in action:

Sally and Rita are both successful business women who own their condos in Detroit.  They both have $50,000 in home equity on $150,000 apartments.  Their monthly expenses are $3,000, $500 of which is discretionary spending.

Sally has:

• Checking $1,000
• Emergency Fund $15,000 (6 months at $2500)
• Student debt $20,000 6.9% apr

Rita has:

• Checking $1,000
• Emergency Fund $0
• Student Debt $5,000 6.9% apr

At this moment in time they have an equal amount in net worth, however, with a much smaller principle on the loan, each month Rita will be saving more.  Should no emergency occur, she is in much better shape.

Of course, the purpose of an Emergency Fund is to cover those times when things go horribly wrong.  So in the case of Rita, should she lose that job her mortgage payments are at risk, which in turn jeopardizes the home equity amount of $50,000 via lien.

If Rita was to walk into a financial planners office on this day, or listen to the billion blogs about the topic, the advice would be ‘start building an emergency fund immediately’.  However, that is actually bad advice even for advocates of emergency funds, because if an emergency occurs a week from now, Rita is still up the creek without a paddle.  If you are an advocate of emergency funds but allow someone you advise to walk around without one, you are doing a disservice.

The only solution to cover the emergency fund need would be to instantly create one via release of equity or taking on new debt.  In this case, taking a home equity loan, and sitting on the money.  A HELOC wouldn’t work because the promise of borrowing might be removed at the most needed time.

Does something feel odd about this?

Simply put, conventional ‘wisdom’ states that it would be wiser for someone to take out a loan (in this example a home equity loan) in order to fund a non-existant emergency fund. Just in case the worst happens.

What if the worst happens?

The crux of an Emergency Fund is that it is insurance against catastrophic loss. If you consider other forms of insurance, such as life insurance, or home insurance these come with a premium. 

This begs the question, should everyone have all of these types of insurance all the time? I’d propose the answer is no.  Life Insurance is not needed by everyone, all the time, but there are times when one might need it.  The same with home insurance. Clearly if you are renting or living with parents you don’t need homeowners insurance.

The same can be said for an Emergency Fund in my opinion.  Getting one at the wrong time has a real impact as you are paying a ‘premium’ on it.  In the case of Sally and Rita that premium could be as high as 6.9% of $15000.  If you were to amortize that student loan over 5 years you’d be looking at almost $1,000 in interest in the first year, and close to $3,000 over the course of the loan.  Essentially this is your ‘emergency fund insurance premium’.

When do you need an Emergency Fund?

Clearly you need one when an emergency happens.. but if you were to approach this as a risk management decision you should focus on three factors:

• Cost of Insurance
• Likelihood of Event
• Impact of Loss

Cost of Insurance

Cost of insurance should be a relative figure to your current net worth.  Therefore if you have $1m in assets and no debt an emergency fund is easy. Let’s say you have $3000 in monthly expenses to cover, that means $9-18K in emergency fund which would be an opportunity cost of 5% (we can do better than Ally…) that is an annual income of $460-920 from your fund. If we picked the average of $690 and look at that as a percentage of $1M it is only 0.069% of your net worth.  If you were to argue about getting an average of 8-10% from the market it still is such a trivial number that it has no real impact.

However, if you have a negative or low net worth the the impact of the debt interest over time as a percentage of your wealth is huge.  An emergency fund could easily be $10,000 by proper standards, and that comes with a cost of $1000 or more per year.  If your net worth is $10,000 then you are losing 10% of your wealth to protect your wealth…

Likelihood of Event

The likelihood of event matters.  If you are changing jobs, even for the better you should consider the elasticity of reserves.  For example, if you get promoted you might think that you are in better shape, but you also may fail in your new role compared to one you know well.  More of a cushion here is wise, but even then you should consider impact of loss.

Impact of loss

If you live at home with parents then the impact of losing a job is minimized. It’s likely that as a unit they can continue to support you.  As such, the fund is less necessary. If like Sally and Rita  you own an apartment, then the impact of the loss is the amount of deposit, plus costs associated with finding a new place to live and the damage to credit reports.  However, this ties back in to likelihood of event.  Not everyone who loses a job will be out of work for a month, or even a day.

Conclusion

The wealthy can afford the cost of an emergency fund, poorer people should consider the impact of one.  The more monthly costs that you are either paying out to debt, or losing out on interest the harder it becomes to shift into a positive net worth.  The question comes down to your goals in life. If it is to become wealthy, you need to think hard about what you spend your money on.

Not having an emergency fund is obviously riskier than having one, but the question you need to always be asking yourself is ‘when can I afford to offload risk for money?’ Do it too soon and you’ll be stuck in debt for years, do it too late and you can lose everything you have worked hard to build up.