Blogs & Comment

Emergency funds and lines of credit

It has long been an axiomthat people should have an emergency fund, equal to about three- to six-months oftake-home pay. But these days Canada Savings Bonds are getting 0.3% and bank accounts not much more than 0.5% annually. This might lead, rightly or wrongly, to some people considering the alternative of establishing a personal line of credit.
Financial emergencies come in many shapes: accidents, illness, funeral expenses, job loss, natural disasters, a family member in need,separation, unexpected legal fees, or an income tax reassessment. If you dont have the cash, you may be forced to withdraw from an RRSP, sell something at a fire-sale price, borrow at high rates (e.g. payday loans), or worse.
David Chilton discussed emergency funds on the fifth-last page of his bestselling book, The Wealthy Barber. He was in favor of a small emergency fund backed by a personal line of credit (he wrote this at a time when bank accounts were paying more than 5% and loan rates on personal line of credits were more than 10%).
One problem with a large reserve fund, Chilton believed, was that persons would succumb to the temptation to convert it to a travel, boat or some other frivolous “want” fund. It would be better just to have a small one and invest the balance in RRSPs or eliminating consumer debt. If a big emergency did come along, one could access their personal line of credit. An exception would be business owners, commissioned salespersons, and people with insecure jobs. –asubstantial cash reserve could make sense for them.
Warren MacKenzie in The Unbiased Investorseemed open to either a cash reserve or a personal line of credit. The main thing for him was just to have access to a source of funds. But the size of reserve should vary according to individual circumstances: beside the nature of ones work, other factors include availability of help from family members, age, and availability of credit.
Others have come out against personal lines of credit. They just dont think it is a good idea to add to ones debt load after losing a job or encountering some other calamity. That could be the start of a downward spiral that ultimately ends in insolvency, especially if circumstances turn for the worse after the emergency e.g. if interest rates ratchet upward.