Sun 8 Jul 2007
Ok, so here’s another attempt at a discussion…? feel free to comment below or do your own post as a trackback to this one.
Almost all financial plans promote the concept of building a pool of “safe money” to cover emergencies and unexpected expenses.? This is certainly a good idea, though to think about it critically, we need to look at the real requirement behind the idea.? The idea isn’t just to have cash in a bank account, the point is to have immediate access to funds if/when you have unexpected situations crop up.
The traditional place for safe money would be a savings account or money market account.? Keeping this pool of money in such a safe place gives you many benefits — almost instant access, near zero chance of loss, etc.? You also have the benefit of knowing exactly how much you have available — maybe enough to cover expenses for 3 or 6 months were you to lose your job/income.
In many respects, you can consider your lines of credit (credit cards, home equity loans, etc.)? as part of your cash reserve.? You have nearly instant access to it — in some cases even quicker than getting money out of a money market account.? You have a near zero chance of losing the credit line — unless you sell your house (for HEL) or close your credit card account.? You also know how much you have available in the form of your credit limit (and your credit score can actually benefit from having a lot of unused credit available).? You can also potentially build a larger pool of safe money if you have good credit — in effect having a credit line that exceeds the same amount you can/would keep in cash.
So, allow me to posit a question — is there a real difference in keeping safe money in cash versus keeping the same amount in available credit?? Some obvious caveats apply — if you aren’t paying off your credit card bill every month or if you have problems overspending with credit, you shouldn’t consider this a choice: keep safe money in cash.
One argument for keeping your safe money pile in cash is that it allows you to use the cash, and then follow with the credit in case emergencies happen in a wave.? In that respect, you have effectively pooled your lines of credit and cash into a larger pool of safe money…? Likewise, some expenses (new car, expected home maintenance, etc.) can be anticipated and shouldn’t be included in this discussion.
Let’s consider two hypothetical examples for entertainment’s sake…
Case 1 – Someone with little to no debt and active investments.? If he were to choose the credit route for his safety pool, he would deploy the extra cash in his brokerage account and put it at risk in investments.? If he had unexpected need for funds he would use his credit.? After the credit spike, he might decide to sell some of his investments to offset the credit (depending on the business case analysis, tax considerations, etc.) or simply pay off the credit over time from his paychecks.? Multiple emergencies that exceeded credit limits would force liquidation of some assets to bridge the gap.
Case 2 – Someone with debt and a debt-reduction plan in place.? If he were to choose the credit route for his safety pool, he would deploy the extra cash to lower his outstanding debt and speed up his debt reduction.? Unexpected funds would cause the credit to increase again, but in this case he’s back where he started (more or less).? A side benefit is that the credit terms might get better during the lower debt periods.
What do you guys think?? Is the psychology of debt too powerful to pull this off successfully?? Does having money in cash let you sleep better at night?
July 8th, 2007 at 11:21 pm
Well, I don’t disagree with anything you said and so perhaps that makes for a dull way for me to contribute to the discussion. I will say that your timing on this issue is freaking me out. I just had a huge set of emergencies dropped into my lap including covering two rents in the same month while transitioning to a new paycheck (which caused a cash flow crunch) and my car died requiring a $3100 engine replacement all on top of a move that hasn’t yet been reimbursed. So consider me a “now” expert.
Fortunately, I had the cash via my portfolios to cover everything but there was a huge delay (nearly 2 weeks) because of the withdrawal process at Oanda and the bank putting a hold on such large check deposits. But it does raise some interesting questions about how my scenario would have played out differently under different setups. Had my money been in cash, I would have avoided the delays but perhaps I would not have had nearly the same level of funds due to lack of earning the higher interest over the past year. Had it been credit cards that came to the rescue, I would have not have been able to do everything (the movers only take certified checks because of the large amounts).
In general I struggle with the issue of any dollar not working for me at its fullest potential (read: highest interest rate) because over time that’s money lost for all intents and purposes. I think that perhaps a small delay in liquidity is even a good thing because it helps you not class things as emergencies that aren’t really emergencies. My car broke down but I just took the bus and waited for the funds for the repairs. Had I not already shredded the hell out of my credit cards (deeply satisfiying), I might have charged it, ended up getting lazy and then carrying the balance or part of it for longer than I planned. Now if Vinnie the Fist says you got 24 hours to pay, then I don’t know what to tell ya.
But what to I do really? I employ a split model called “living on last month’s money”. This means that I build up a buffer of one month’s paycheck in my checking account and that is what this month’s spending comes from. The paychecks that arrive this month sit and wait for the following month. All other savings however gets put in to less-liquid but higher yielding accounts. And thus I sleep better at night for several reasons. I always have enough money to cover bills and fluctuations in cash flow without a thought. But if big trouble hits, I can drawdown on it while waiting for the slow money to arrive. Part of that is a vow to avoid debt at all costs even if it’s painful (I have to walk 2 miles to the bus stop with a laptop bag).
July 9th, 2007 at 8:54 am
The exercise of saving enough cash for an emergency fund is a method used by financial planners to get people accustomed to saving (it’s not the sole reason, but it’s a major factor). With a national savings rate of zero, saving is obviously not something we’re used to doing. However, once you start to save and accumulate enough cash to cover 3 months of expenses, that amount looks really good sitting in the bank and it encourages you to keep going. So in that sense, I think having an emergency account is very good since it often is the first real savings anyone has done.
My approach to “emergency funds” is to keep these funds as cash, but see them as a part of my overall investment portfolio. I don’t like overly compartmentalizing, so the “emergency funds” that remain in a Money Market account are all part of a pool of cash that’s intended for (A) emergencies, (B) planned purchases to be made in the next 1-3 years, (C) an offset for high-risk investments in other parts of the portfolio and (D) a pool from which to regularly draw from to capitalize on investment opportunities.
My gut instinct has me lean far away from using or thinking about credit as an emergency fund pool. I’m seriously credit averse when it’s used to feed consumerism and wants, and I?m with Quicksilver in thinking that it?s often easy to talk yourself into believing something?s an emergency that requires a quick and lazy cash treatment, when oftentimes a little extra thought and pause can make all the difference in saving.
Let?s assume that there was some major house damage that occurred due to a pipe leak ? not enough to invoke your homeowners insurance, but enough to make you consider dipping into your emergency funds to cover the repair costs. With easy credit, you might make a couple calls, find a cheap enough repairman and then move on and the problem?s solved. However, I?m of a mind that if you?re dealing with cash it changes your approach to the problem since the cash is more ?real? and easily identified with your efforts at earning it, so you?ll be less willing to part with it. Thus, you?ll be more inclined to be inventive in your approach to solving the emergency in more novel ways, such as taking on some of the repairs yourself or finding workarounds or haggling more aggressively with the repairmen over costs (many will yield on the price since the price of repairs on most jobs is fairly subjective anyway).
The above story might not apply to all situations or individuals, but I?ve seen many of my friends who are in financial difficulties get really really creative in solving problems without using a penny more than was absolutely necessary. I like this approach, since there are millions of ways to part with your money, but so few ways to earn more. Credit and more specifically, easy credit, hurts this essential concept that earning money is hard and thus we should take a far more protective stance to aggressively protect this money, even in times of crisis and emergency.
A quick digression on credit, if you will: I’m seriously averse to buying anything with credit or leveraging credit to “supersize” something, vs. staying within the boundaries of what I can afford with cash and only buying items that are planned purchases (not impulse buys). Granted, those last two sentences are a bit preachy and drift away from the discussion topic of whether credit is good to use as an emergency fund source, but hopefully this helps explain a bit my preference towards cash for emergency funds.
My approach to credit cards is very narrow: I see credit cards as a means of capitalizing on getting interest free money for 55 – 25 days for everyday purchases, and taking advantage of convenience and 1% – 5% money back on everyday purchases. That’s it. I know I’m not taking advantage of other services that they offer or using them to leverage myself into a more bling-bling lifestyle, but I’ve fallen into this trap before and got majorly in debt, and thus I keep a wide berth around these cards to ensure that spending pattern does not re-emerge. By using credit cards in the way that I do, I augment my cashflows by roughly $900 per year by getting $600 in cash back and getting roughly $300 in interest by allowing the money that is alloted for everyday purchases to accrue interest before I pay the credit card bills (always with only 2-3 days to spare on the bill due date). To get this $900, I offer up key identity information to the credit card companies regarding my spending habits, and it takes a little more work to ensure that money gets moved into my money market account regularly and back out in time to pay the bill, which has scheduled payments. Calendar reminders make this easy.
Sorry for rambling on!
July 10th, 2007 at 10:59 pm
Thanks for both your perspectives… it’s always good to hear some other experiences with something like this.
For my case, I have safe money in cash/money market for convenience and safety. I also get ~5% yield on that money market, so I feel that it is working for me with a good risk/reward ratio (minimal risk, reasonable rate of return) compared to other investments where I feel the risks are higher (see Quicksilver’s post on sharpe ratios).
That said, I also have my primary credit card and a few backups… not for emergency spending but more for emergencies like identity theft. Having been a victim in the past, I know that if a credit card is tainted, it takes a few days for a replacement (with a new, clean number) to be sent to you. But that’s a separate topic…