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Rainy day funding revisited

By Dr. Don Taylor ·
Tuesday, December 31, 2013
Posted: 6 am ET

Most financial planners advise clients to have some liquid funds set aside for a financial emergency. The typical recommendation is three to six months worth of living expenses, although that number has been creeping higher since the 2008 financial meltdown and subsequent high unemployment rates.

Clients resist it for a host of reasons, including the low yields available on short-term savings vehicles, counting on loans to bridge the gap and denying the odds that they will face a financial emergency.

What's a financial emergency? It could mean a job loss, needed home or car repairs, a health issue or a disability. While insurance coverages can meet some or all of these financial needs, that coverage needs to be in place prior to the financial emergency.

Short-term savings vehicles are the conventional recommendation for where you should hold your emergency fund. Money market mutual funds, money market accounts and high-yield savings accounts provide the liquidity and safety of principal for consumers to know that money is available when it's needed. In today's yield environment, high-yield savings accounts are likely to be the best choice among these savings vehicles.

Alternately, as I've written about before, you can decide to venture out on the yield curve and invest in longer maturity certificates of deposit, either in a laddered CD portfolio, a barbell portfolio or just long CDs and accept the risk that you may have to cash them in early and pay the interest penalty for early withdrawal of the deposit.

What about loans to finance the emergency? A plan loan from a 401(k) or 403(b) plan generally is not recommended because plan loans become due and payable if the person should be separated from service. If the loan isn't repaid, it's considered a distribution and subject to income tax and, depending on the former employee's age, a potential 10 percent penalty tax.

What inspired this blog post was an article in October issue of Financial Planning titled "Time for Advisers to Revisit HELOCs?" by Donald Jay Korn. A home equity line of credit, or HELOC, can be an alternative to keeping liquid funds in a savings account.

I soured on HELOCs as an emergency fund substitute during the housing crisis when lenders were reducing credit lines available based on falling home values. People, counting on these lines as a financial backstop, saw them taken away. I also took exception to the banking industry going from a pricing model where borrowers' interest rates were based on the prime rate plus or minus a small pricing spread to one where the loans are still based on the prime rate but had floor rates 1 percent to 2 percent above the prime rate, which is currently at 3.25 percent. Bankrate's national average for a HELOC is, as of this writing, 5.2 percent.

That said, I don't want to be the general fighting the last war. HELOCs can offer a homeowner a measure of financial flexibility and tax deductibility to lower the effective rate of the debt. If the homeowner can get a competitive rate with low closing costs and is pretty confident that housing prices have turned the corner in his or her market and are at least stabilized if not appreciating, a HELOC can stand for part of the consumer's needs for emergency funds.

Do you have an emergency fund or are you counting on loans to get you through? How many months worth of expenses will it cover?

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