This past week, I’ve been thinking a lot about emergency funds. I read some great articles by,, and, and I believe that the role of an emergency fund is certainly under-discussed and over-simplified in the financial planning world.

The major role of an emergency fund is to prevent someone from going into high-interest credit card debt due to an emergency. Everyone should take some time at least once or twice a year to think about their range of expected emergencies and how they can be funded without going into high-interest credit card debt. There is a spectrum of potential outcomes, and there shouldn’t be a strict rule of thumb for the best amount in an emergency fund because everyone’s situation is different. A family with two steady incomes, but could live off of one, and with ample equity in their home probably doesn’t need an emergency fund of more than a month or two, depending on their potential emergencies. A single person with a tenuous job and a car on the fritz may need a larger emergency fund, especially if he does not have any equity in a house or money in a taxable brokerage account to utilize.

This ties into my Dynamic Cash Allocation plan, in which we all need to look at our current investment and debt options, adjust them for taxes and inflation, and make reasoned projections on how those options compare now to the next few years. Your excess cash flow also has a significant role in the analysis, as it dictates how quickly problems with your emergency fund can be solved.

Two tools need to be in your toolbox regarding your emergency fund, in addition to just leaving it in cash. One is setting up a HELOC (home equity line of credit) and using your emergency fund to pay down your mortgage. If your mortgage interest rate is 4% (3% after the interest deduction) and your emergency fund pays 1% (0.75% after interest taxes), and you can access all of your emergency fund through the HELOC once you use it to pay down your mortgage, then that is worth considering. Make sure that your HELOC is free to set up, cheap to maintain, that the interest rate and LTV requirements are reasonable and that it can’t be called or closed if the real estate market declines, as the biggest risk is that you put your emergency fund into your house and then can’t get it back out.

The second tool is to invest the money in a taxable brokerage account. From there, you can either sell some securities if money is needed, or else borrow from the account on margin, albeit at a higher interest rate than the HELOC. Of course, the expected rate of return on the investment needs to be higher than the expected savings on paying down the mortgage, and it needs to be higher to a degree that factors the risks with investing, as the mortgage interest savings is fixed. If the stock market were down significantly right now, I might consider investing part of an emergency fund in the market; however, when it is expensive, the better course of action may be to take advantage of a HELOC or just leave it in cash. Keep in mind that you could also put the money into your house to get the best risk-adjusted rate of return now, and then if the market ever becomes cheap again, borrow from your HELOC and invest that money in the market (assuming that interest rates are still reasonable). It may sound risky, and I’m not advocating for this approach, but that is the choice we are all making when we choose to invest over rapidly paying down debt.

Regardless of what you do, the key is to think about your situation, your risks, your opportunities and how they may change over time, in deciding what to do with your emergency fund.