[DMat]

If you had a mortgage (or other debt, or just good secure investment opportunities, like one's RRSP), which would you do:

(This isn't a poll because I'd rather hear your reasons than tally opinions)

1) Keep an emergency fund
2) Pay whatever excess funds you have into your mortgage//RRSP and have a line of credit for any emergencies

I'm siding with #2 as long as you are assured that your line-of-credit won't get cut back in the event of a major emergency. I think of #1 as a guaranteed loss of growth to protect yourself against what is supposed to be an unlikely event.

If you choose to do #2, you're spending your emergency fund frivolously, you're just optimally allocating it. If a real emergency hit, you could withdraw on it (maybe not instantly, but if you racked up debt against your secured line of credit, you could just repay it when you renegotiate your mortgage, right?)

Any comments?

 

[mfd]

I'd rather have hard cash. The last thing I want to worry about is my LOC even if it is secured. I also won't have to worry about servicing the loan which if the rates are high could get quite expensive.

 

[MGL]

I'm siding with #2 as long as you are assured that your line-of-credit won't get cut back in the event of a major emergency. I think of #1 as a guaranteed loss of growth to protect yourself against what is supposed to be an unlikely event.

If you can be certain that your LOC will be there, it's probably a good plan, but the problem is that you can't be certain. The times when you need an emergency fund the most are the exact times when your ability to obtain credit is most in jeopardy and your LOC is most likely to be unavailable. You can use access to credit or saleable assets as a reason to reduce the size of your emergency fund, but to eliminate emergency savings altogether is a risky proposition.

You're right that this results in a loss of growth, but so do many other things. Most insurance premiums, for example, are a likely loss to protect against an unlikely event. Maximizing growth is important, but it needs to be balanced with just a touch of conservative planning.

 

[CanadianCapitalist]

1) Keep an emergency fund
2) Pay whatever excess funds you have into your mortgage//RRSP and have a line of credit for any emergencies

I was of the opinion that #2 was better because of the reasons you point out... In fact, that's what we did when our mortgage was much larger than it is now. But, the problem with this approach was revealed in the current credit crisis. If things get really bad and we do need to tap into the credit line, it may not be there and it may be difficult to get another one. If I were starting over now, I'd go with #1.

The size of the emergency fund will also be dictated by your personal circumstances. If both spouses work, the risk may be lower and a smaller fund may be appropriate.

 

[FrugalTrader]

If you had a mortgage (or other debt, or just good secure investment opportunities, like one's RRSP), which would you do:

(This isn't a poll because I'd rather hear your reasons than tally opinions)

1) Keep an emergency fund
2) Pay whatever excess funds you have into your mortgage//RRSP and have a line of credit for any emergencies

I'm siding with #2 as long as you are assured that your line-of-credit won't get cut back in the event of a major emergency. I think of #1 as a guaranteed loss of growth to protect yourself against what is supposed to be an unlikely event.

If you choose to do #2, you're spending your emergency fund frivolously, you're just optimally allocating it. If a real emergency hit, you could withdraw on it (maybe not instantly, but if you racked up debt against your secured line of credit, you could just repay it when you renegotiate your mortgage, right?)

Any comments?

I think it's a personal decision. It's probably more efficient to take excess funds to pay down debt, but to some, it just "feels" better to have cash on hand. We're a prime example of the latter, we have a mortgage of over $75k, but we hold about $40k in cash.

Mind you, we will be moving some money to pay down the mortgage soon because we have set a new mortgage pay off goal, but to us, having cash on hand feels "safer".

 

[Rickson9]

If you had a mortgage (or other debt, or just good secure investment opportunities, like one's RRSP), which would you do:

(This isn't a poll because I'd rather hear your reasons than tally opinions)

1) Keep an emergency fund
2) Pay whatever excess funds you have into your mortgage//RRSP and have a line of credit for any emergencies

We don't have a mortgage on our personal residence, but we have an emergency fund and a LOC as well.

 

[Ben]

I would throw my vote behind everything that's been said by MGL, CC, and FT. Collectively, they've covered the point well.

 

[DMat]

Should one be worried so much about their line of credit getting cut back to such a significant degree, especially if they've built significant equity within their residence that the LoC is secured against?

I thought that, for the most part, people just got their LoC interest rates increased a bit (so far anyways), am I wrong on this?

And I was thinking of the insurance analogy while I wrote the OP. My opinion of insurance is that it's always a poor investment, unless you know that your risk is significantly higher than estimated. But in most cases, it's a necessary evil for immitigable risks (your house burning down).

 

[Financial Highway]

As CC said in the past I would have also voted for option nr.2 but this credit crisis has illustrated the importance of an emergency fund.
Emergency is the wrong time to get into debt.
Emergency fund is your life line, when life gets though. If you have build a sufficient seize emergency fund and have insured yourself properly you will be able to handle any type of emergency. Without the EF i think you are leaving yourself very vulnerable.

 

[CanadianCapitalist]

Should one be worried so much about their line of credit getting cut back to such a significant degree, especially if they've built significant equity within their residence that the LoC is secured against?

I'll agree that the risk is very low. But it is there. My secured LOC has this statement in bold letters, no less:

At any time, if we ask you, you must pay us the total amount you owe on your credit line.

Granted, you can take other steps, if such an even should come to pass but I've decided that I'd rather sleep well at night knowing there is a small pot of cold, hard, cash stashed away.

 

[markievicz]

but this credit crisis has illustrated the importance of an emergency fund

This situation is a good "test", isn't it, of all the theory? I have a far clearer sense of my comfort levels with risk, cash on hand etc than I have ever had.

I'm another that likes having lots of cash around, I'm afraid. Old house + family abroad + itchy feet career-wise + just generally being neurotic, I guess.

 

[George]

I'm with #1 - having an emergency fund of at least a few thousand bucks is reassuring to me moreso than a slightly lower mortgage balance.

 

[schmengei]

Pay down debt. John Templeton said it was his first rule of investing. Pay down debt. Do the math on any loan vs. investment. Please come up with a formula that calculates investing in anything will come out ahead of paying down debt first, after interest and time/inflation/. IOW - after debt then invest = sovereignty IMO.

 

[johnsazzr]

As CC said in the past I would have also voted for option nr.2 but this credit crisis has illustrated the importance of an emergency fund.
Emergency is the wrong time to get into debt.
Emergency fund is your life line, when life gets though. If you have build a sufficient seize emergency fund and have insured yourself properly you will be able to handle any type of emergency. Without the EF i think you are leaving yourself very vulnerable.

+1

Eventhough I am a financial advisor..my first rule of investing personally and for my clients is "pay down debt"

 

[michika]

I'm all about number #1 in this case. Twice in the last 6 months have had to dip in or liquidate my emergency fund. Once for a seriously prolongued illness, and a second because my bank made a horrible error and froze ALL my accounts, credit included, for 8 days. Thankfully I keep my emergency fund elsewhere and it cost me all of $1.50 in service fees to access it.

Although then again people tell me I'm crazy. I keep $100 in emergency cash in an envelope taped under my desk at home. A left over habit I've had since university. I like the quick and easy access to cash, with no immediate need to repay anyone other then myself.

 

[Mockingbird]

A bit out of topic, but here's an interesting story about how some line of credit customers got the hefty rate increase recently.

http://www.timescolonist.com/opinion/op-ed/Credit+union+reduces+line+credit+rate/1450905/story.html

 

[UpNorth]

My partner and I have been giving this topic a fair bit of thought lately. When we started planning our finances about two years ago we decided to throw everything we had at our debt (student loans and car loan) and we did not build up an emergency fund.

Right now we're headed for a potential emergency - her job is at serious risk. Our solution was to immediately suspend big purchases and stash away what cash we could - including banking our tax return and reallocating honeymoon savings to the emergency fund. We were able to pull together $5,000 by doing this. If she's laid off, she'll get a severance of about $7,000.

Our plan is to continue to pay off our loans as usual until she gets a layoff notice at which point we'll reduce our loan payments and sock away cash for the next few months while she's still working (once she gets notice she can work for three months before her job ends). Once her job ends, she'll reduce her loan payment to the minimum and get EI. With minimized loan payments, her EI is quite sufficient. Paying off her loan will take a bit longer, but we'll have roughly the same income as before and about $15,000 cash on hand in an emergency fund.

I wouldn't say we regret not building up an emergency fund because we were able to pull together cash from other sources in a jiffy.

All that said, we're hopeful she won't lose her job but being cautious nonetheless.

 

[The_Number]

I'm not exactly practising what I preach (but I'm working on it), but I think an emergency fund is important. Right now, I have a small pool of emergency fund (about 1 month of expenses) + saving that is earmarked for other purposes. Because of this setup, I can (like UpNorth) divert these earmarked saving (and current cashflow) as emergency fund if there is an emergency. But I would like to get to a point where I have a dedicated line of enough emergency fund.

The size of the emergency fund will also be dictated by your personal circumstances. If both spouses work, the risk may be lower and a smaller fund may be appropriate.

Shouldn't you need more (not less) if both spouses are working? By having two people in the workplace, you are doubling the probability of an emergency (This is American statistics before the current recession, but the probability of a layoff in any given year for a single-income family is 1/32; but the probability is obviously doubled [= 1/16] for a double-income family.)

 

[DAvid]

Shouldn't you need more (not less) if both spouses are working? By having two people in the workplace, you are doubling the probability of an emergency (This is American statistics before the current recession, but the probability of a layoff in any given year for a single-income family is 1/32; but the probability is obviously doubled [= 1/16] for a double-income family.)

The statistical likelihood of both losing their jobs is multiplied, not added. If the probability of a coin toss showing heads is 50%, then the probability of tossing two heads in a row is not 100%, but rather one in 4 or 25%. In your instance the chance of both losing their independent jobs is 1/32 * 1/32 = or about 1/1024.

If they both work for GM or Chrysler, on the other hand......

DAvid

 

[The_Number]

The statistical likelihood of both losing their jobs is multiplied, not added. If the probability of a coin toss showing heads is 50%, then the probability of tossing two heads in a row is not 100%, but rather one in 4 or 25%. In your instance the chance of both losing their independent jobs is 1/32 * 1/32 = or about 1/1024.

If they both work for GM or Chrysler, on the other hand......

DAvid

Yes. The statistical likelihood of both losing their job is 1/1024. I was referring to the likelihood of one of them losing his/her job.

The double-income households have other increased perils, too. e.g. if their children/parents get sick and need to take time from work, that has income consequences (rather than sending the non-working spouse). The same thing with disability; the likelihood of one of them becoming disabled doubles for double-income family. If the worker in a single-income family loses his/her job, the non-working spouse can get a job to make up some of the differences. If both spouses are working, sending an "additional" worker is usually not an option (This stuff comes from E. Warren's "Two-Income Trap.")

I concur with CanadianCapitalist in that the level of emergency fund should reflect personal circumstances, but a more relevant factor is probably cashflow (e.g. if a family can live on a single paycheck in a double-income family, then the emergency fund can be smaller. On the other hand, if the family need the two pay checks to cover the basic expenses, the emergency fund level should be higher than that of a comparable one-income family or even a single.)