Most financial planners advise keeping emergency funds to cover three to twelve months living expenses in a savings account or money market fund. For the vast majority of people, it is the sensible thing to do. However, like most recommendations, this one-size-fits-all approach is not suitable for everyone.
Take someone who is very disciplined with spending, has a lot of equity in their home, has a secured line of credit against the home, is paying a mortgage and also has cash parked in an emergency fund. I would argue that this is an inefficient allocation of capital. Instead, they can take most of their emergency funds and make a pre-payment on their mortgage. They start saving mortgage interest immediately, which in most cases will be much higher than the taxable interest in a savings account. In an emergency, they can withdraw necessary funds from the secured line of credit.
Of course, this approach is not for everyone and should be considered very carefully. There are risks involved: the prime rate during an emergency could be much higher than their mortgage interest. If emergencies are a high-probability event, having an emergency fund is the better alternative. Also, it is critical to be disciplined about the secured line of credit. A month’s vacation in Hawaii is not an emergency.
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1 » Carnival of Personal Finance #53 » Consumerism Commentary: A Blog About Personal Finance // Jun 18, 2006 at 9:49 pm
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2 Canadian Capitalist » On Vacation // Jul 23, 2006 at 12:21 pm
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