The goal of having an emergency fund is two-fold. For one, your emergency savings can replace your income (at least for a few months) should you lose your job. But an emergency fund has another equally-important function: to allow you to pay for large, unexpected, and unavoidable expenses without incurring debt or borrowing from other savings accounts (e.g., college funds or retirement plans). With the focus these days on the economy and job losses, everybody’s so intent on protecting their emergency fund in case they lose their job, they may be more willing to save instead of pay down debt, or even pay for an unexpected expenses from other sources like credit cards. Is this smart? Consider this example I received from a 28-year old reader:
I need $2,000 to retain an attorney for an upcoming child custody trial and between $1,000 and $2,000 more for all of the anticipated legal expenses. Here is my financial status:
- $2,100/month net salary
- $10,000 in low-interest credit card debt (under 5%)
- $70,000 mortgage ($59,000 remaining balance)
- $1,200 in an emergency savings account
- $1,300 in a 529 savings account
- $6,000 in a Roth IRA
- $13,000 in a 401(k)
What’s my best route for coming up with this money? I’ve considered several options including a home equity line of credit, home equity loan, borrowing against my 401k, and a personal loan. I’ve also thought about cleaning out my emergency fund, but in the current economic climate, I’d rather leave that alone. I could also clear out the 529 savings account, since I have only just started and I have many years before that will be required.
Although this reader’s financial snapshot isn’t bad, especially in today’s economy and for being 28; you can see the pickle he’s in. His emergency fund is low, and draining it won’t cover the entire cost of this unexpected expense and will leave him vulnerable should he lose his income.
What are his options? Since rates are low, you could try for a home equity loan or line of credit and it wouldn’t be the worst idea. The only problems I foresee, however, is getting approved in today’s tough credit markets and that banks may not see the $11,000 in equity you have to be enough for a loan. Borrowing against a 401(k) is rarely a good idea since the loan comes due should you leave your job, meaning you’ll have to pay taxes and penalties if you can’t immediately repay the balance. Similarly, although you just started the 529 savings account, you would also have to pay taxes and a 10% penalties on an early withdrawal, so that $1,300 turns into more like $900.
Another option you have is withdrawing some principal from your Roth IRA. One of the beauties of Roth IRAs is that you can withdraw money you contributed to the fund anytime without paying taxes or penalties. Of course, you’ll also be sacrificing earnings during that time.
What I would do. I would lean on that Roth IRA for peace of mind in case you lose your income. I would drain the emergency fund for these legal expenses and look for other ways to come up with another $800 for the rest of the retainer. Anything around the house you can sell? Some part-time work you can pick up? You can even try negotiating with the attorney to see if he’ll set the retainer at $1,500 while you come up with extra funds. Then, slash your budget and/or pick up extra income to rebuild your emergency fund and pay for the additional legal expenses. In the worst case scenario, all of the options you mentioned are available to you, but my guess is you can get this expense paid for (and your emergency fund built back up) without touching your other finances.
What do you think? Would you drain your emergency fund to cover a big expense despite the economy or would you look at other options? What do you recommend this reader do? Let us know in a comment.