Why Do I Need an Emergency Fund?

Life happens.  And then you need a big chunk of money to pay a dental bill, a car repair bill, a deductible on your medical insurance, a replacement of your water heater.  Anything that throws your normal living expenses out of kilter.

So where do most people go to get those funds?  Why, the cash withdrawal feature of your credit card, of course! Except that is the most expensive way to get it.  First, there is a fee based on a percentage of the money you borrow  which could be as high as 5%.  Then there is the interest rate on cash advances which is significantly higher than that charged to purchases.  By the time you pay off the advance, you will have paid off about 135% or more of what you borrowed.

There are other ways to accumulate your emergency fund.  Like trying to set aside something from every paycheck until you have amassed about 6 months of your living expenses in one spot in a money market fund.  That, most people say, is impossible.  So is repaying the loan at 135% of what you borrowed!

There is also a home equity line of credit.  The interest rate on home equity lines of credit are variable and at this point, are under 5%.  And you only pay back (please pay on the principal you borrowed!) what you took from the line of credit.  Unlike a loan where you make a monthly payment based on the full amount you borrowed plus interest, the home equity line of credit works similarly to a credit card.  You only pay on what you borrow and you are only obligated to pay the interest on the loan, not the principal.  But that soon becomes a fool’s game if you ever want to get it paid back.

Consider a loan from a permanent life insurance policy.  The cash value is collateral for money you need to borrow and again you do not need to pay back the principal.  It, too, will eventually implode if you do not pay the principal and the interest on that loan.

Best course of action: have 10% of your paycheck automatically moved to a savings account every pay period.  That will accumulate very fast.  It’s amazing what peace of mind that little rainy day fund will give you.

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