8 Alternatives to an Emergency Fund
Most financial experts say everyone should have enough money saved to cover at least 3 months of living expenses. I tend to think 3 months about the right amount if you have net worth you can fall back on. Let me be clear: there really is no alternative to a liquid emergency fund. However, some people don’t like to see that much cash sitting around idle. So, I’ve made a list of 8 ways you can tap into your net worth in an emergency.
Take Out a Home Equity Loan or HELOC
Homeowners can borrow some of the equity in their home in the form of a home equity loan, usually up to 80% of the home’s value. If there is an outstanding mortgage balance, simply subtract that from 80% of the value. For example, let’s say your home is worth $350,000 and you owe $150,000 on it. You would be permitted to borrow up to $280,000 (80% of $350,000), less $150,000 (the mortgage balance), so $130,000 would be the amount of the home loan. The homeowner gets this money at once, and pays it back over time, usually with a fixed interest rate.
Often, home equity loans and Home Equity Lines of Credit (HELOCs) get confused or used interchangeably. They are different, though. With a HELOC, the homeowner would be permitted to borrow the same amount as in the above example, but they wouldn’t have to borrow the entire amount. They pay interest on only the amount of money drawn down from the line of credit, and the interest rate is usually variable.
The biggest risk to forgoing an emergency fund and falling back on either a home equity loan or a HELOC is that if the borrower is unable to pay those loans back, they would lose their home because the home is collateral. It’s also worth noting that it takes time to get approved for these loans, so the only way they would help in a true emergency is if you’d already gotten approved for them.
Take Principal Out of a Roth IRA
A Roth IRA is an individual retirement account that is funded with after-tax dollars. The invested funds grow throughout the investor’s working years. If the investor needs access to liquidity before 59 ½, they can take money out of a Roth IRA penalty-free, as long as they only take out what they’ve put in. If the investor takes out any of the investment income, there are penalties. It should be noted here that decreasing the value of your retirement is generally not a good idea and should be avoided. Also, please that this is not a loan. For more information about Roth IRA’s, check out this blog.
Borrow From a 401(k)
Most 401(k) plans allow investors to borrow up to $50,000 or 50% of the value in their 401(k), whichever is less. Borrowers are typically required to pay back the loans within 5 years in quarterly payments. Those payments include interest, and the interest is be less than most other kinds of loans. So, the borrower basically pays their own retirement account interest. It is not ideal to deplete the value of your retirement; however, it may be a better option than borrowing from elsewhere and paying a high interest rate. For more information about 401(k)s, check out this blog.
Borrow from a Whole Life Insurance Policy
Whole life insurance pays out a death benefit when the insured dies, whenever the insured dies. It is a permanent policy, so it has no term or expiration. The owner pays level premiums over time. A portion of each premium goes towards the death benefit and part of it goes towards savings. The savings portion, which is called the cash value of the policy, earns interest over time. The owner of the policy can borrow money from the cash value without going through a loan approval process. The interesting part about this loan is that is technically never has to be paid back. Although the balance will accrue interest at a low rate, when the insured dies, the insurance company will simply pay out the death benefit less the amount of the loan and interest that has added up over time.
Take Out a Personal Loan
Another option available is a personal loan, where the borrower receives a lump sum and pays that balance off over time. The interest rate could be as reasonable as 5% or as high as 36%. The lender pulls the borrower’s credit and the loan appears on the borrower’s credit report. There can also be origination fees.
Use a Credit Card
Some people consider their credit limits on their credit cards to be their emergency fund. Many Americans do not have enough cash to fund a large, unexpected expense. They know that if a $1,000 car repair bill arises, they can use their credit card to pay for it, as long as their available credit is higher than $1,000. That is all well and good until the borrower can’t pay the balance off right away. Interest accumulates quickly on credit cards because of their high interest rates, especially if borrowers only pay the minimum amount due. A credit card is not a good substitute for an emergency fund. For more information on credit and credit scores, check out this blog.
Withdraw from a Certificate of Deposit (CD)
CDs are a way to get more interest for deposited funds than a traditional savings account. Financial institutions are able to offer a higher interest rate in exchange for the depositor agreeing to leave the money there for a specified period of time, like 6, 12, or 18 months. If a depositor needs to access their money in an emergency, they are able to do that, but they are charged an early withdrawal penalty of some number of months’ interest.
Sell stocks and bonds
If an investor is so inclined, instead of keeping money liquid in a savings account as an emergency fund, they could put that money in the stock or bond markets. Naturally, a risk with this option is that the investor puts money in the market, the market collapses, and then the investor has an emergency need for money. For example, if you need to have $50,000 for emergencies and you invest that in stock, and the stock market drops 20% right when you experience an emergency, you’d only have $40,000.
There are pros and cons to each of the above options. Borrowing from a 401(k) or taking the principal out of a Roth IRA decreases the value of retirement. Using a home equity loan or home equity line of credit puts the house at risk as collateral. Personal loans and credit cards typically charge high interest rates. Loans from whole life insurance policies decrease the death benefit beneficiaries will receive upon the death of the insured. Withdrawing money from a certificate of deposit results in fees. Keeping an emergency fund in the stock or bond markets could result in a decrease in value of the funds. The safest place for an emergency fund is a savings account. Ideally, emergency funds should be kept in online savings accounts, where the interest received is a bit higher than traditional banks, and the fund is out of sight and out of mind. That way, the fund is guaranteed to increase in value, and you won’t have to pay interest in case of an emergency.