Overrated Emergency Funds

This should be controversial.

Disclaimer

This assumes you are pretty far along on your net worth accumulation. You aren’t ready to retire yet but you do have substantial stock investments. By substantial, I mean perhaps over $100,000 saved in a margin stock account or well over $100,000 equity in your home.

Purpose of Emergency Fund

Some people believe you should keep 3-6 months of cash to cover living expenses in case you lose your job. I do not believe this applies to people with higher net worth and access to cheap liquidity.

If you lose your job, you’ll likely collect unemployment. You’ll likely also cut your expenses. You’ll only need to cover the gap between your unemployment check and your new lower expenses. You’re already saving half or more of your income right? So the idea of saving enough cash to replace 3-6 months of income is silly.

Margin Account

In my opinion, the #1 emergency fund alternative is a margin account at a low-cost brokerage such as Interactive Brokers (affiliate link, disclosure). Here’s why:

  • Over $100,000 at IB avoids monthly activity minimum fees, so your account will be free. If your balance is under $100,000, they charge a minimum activity fee of $10 minus any commissions you have for the month
  • IB always has some of the lowest margin rates. Currently ~1.99% but has been as low as 1.3%. Compare to most other retail/discount brokers charging 4-8%
  • With a margin account, you can withdraw funds without selling stock – selling stock triggers tax implications such as capital gains tax. You also miss out on market returns
  • Withdrawing $10,000 would incur $199 of interest per year or only ~$16.58 per month
  • Easily paid back through your automatic contributions you are already doing, or add extra funds anytime to pay off early

So instead of setting aside $9,000-25,000 cash for an event that may be unlikely for you, I would put that emergency fund straight into the market along with all my other money. In the unlikely event that there is a job loss or major unexpected expense, just withdraw the needed funds temporarily on margin. The long run market gains of not having that cash sit around for years earning nothing will far outweigh the brief low-interest expense of a margin withdrawal and you won’t have to pay capital gains tax from selling investments.

Home Equity Line of Credit

Another option is a home equity line of credit. The rules vary by state. But essentially, the equity of your home is used as collateral for a line of credit. You can withdraw equity from your home as needed. Because your home is collateral, the interest rate is relatively low, though usually higher than a margin loan. You can get anywhere from 2.75-5% depending on the terms which often range from 6 to 15-year amortization periods. Some are interest-only.

HELOC interest is tax deductible up to $50,000 borrowed. Depending on your tax bracket, this can also make for an interesting alternative to a traditional car loan. If you are in a 25%+ tax bracket, a 4% interest only or 15 year HELOC is effectively 3% interest rate and a payment significantly lower than a traditional car loan. But that’s a topic for another day.

If you don’t have a sizable margin account at a broker such as Interactive Brokers (maybe you are still focusing on maxing the 401(k)), but you do have a lot of equity in your home, check out a home equity line of credit.

Taxes

Margin Account loans are not tax deductible if you use them for purposes other than investing, so that’s something to consider when comparing interest rates between a margin loan and HELOC draw.

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