Do you need an emergency fund? Reflexions on what to do in a high inflation, low interest environment

Tyler and Claire require $85,000 to renovate their house but started saving late and now want some advice.  So the Globe and Mail enlisted the services of TD Waterhouse investment advisor, Eric Davis.  The first thing, he says, is to establish an emergency fund:

Before they begin their renovations, though, Tyler and Claire should build up an emergency fund of anywhere from $15,000 to $30,000, which could be held in a tax-free savings account, he adds.

The standard wisdom today coming from financial advisors is that everybody needs to have an emergency fund.  Usually this consists of up to as much two-years worth of living expenses to tide one over in case of illness, unexpected expenses such as car or home repairs, or loss of a job.  All is good.  Save for rainy day?  Seems like pretty sound advice, right?

But in my mind, it isn’t sound advice in all circumstances.  Why?  Because the spread between the savings interest rates and mortgage rates is usually about 3-5 %.  So you can get 1% interest in your savings account; but you pay 4% on your mortgage.  Why not make an extraordinary payment on the mortgage, and save 3% in the meantime?  The problem is one of liquidity.  The money one uses to pay down a house is illiquid and you can’t access it in an emergency.  So that is why I recommend instead to get a line of credit, preferably a home equity line of credit (HELOC) because they have the lowest interest rate.  As you pay down the house, the bank will increase the HELOC.  Now use the HELOC only for emergencies and any excess cash can pay down the mortgage, saving you 3% interest in the meantime.  Interest earned is taxable, except of course in the TFSA (Canadian Tax Free Savings Account).  The government gets its cut.  Interest saved is not taxable.  So the home owner makes a double win.

I think it is necessary to be extremely wary of the advice from financial advisors because they don’t work for you.  Do you ever wonder why your advisor will make a trip to your house and spend a couple hours working out a financial plan?  Who pays them?  Our broker from Scotia McLeod did that; and Scotia McLeod earned full standard commissions from us: that means 2% or an $80 minimum per transaction.  One time he wanted me to put a stop loss on RSI.un (Rogers Sugar) saying that I’d made some nice gains, I should try to lock them in.  Well I didn’t want to do it because Rogers was paying a tidy dividend every month.  He insisted and finally talked me into it.  When all was said and done, the stop loss evacuated the stock at a $30 dollar after-commission loss to me, my broker got is his fat fee for selling it, and I lost a source of income.  I wanted the long term position for the dividend, but the financial industry made money churning my position.  Today, RSI has continued to pay (now monthly) and it is trading at 25% higher than my stop loss.  I would have won if I held it for the last six years which was my intention.  But the industry doesn’t make any money when you hold, only when you churn.  This incident is one of the reasons that I become a DIY investor.

Eric Davis would probably offer the couple a TFSA account at an anaemic rate of interest at TD Bank. Such a savings account will help the bank, for banks crave savings accounts, needing of capital these days.  But the inflation rate is greater than the interest rate by at least 2 basis points, and so now Tyler and Claire will lose 2% buying power on every dollar in their TFSA; if hyperinflation hits, and in my mind that is certain, then they could lose double digits or higher–food prices are going up like crazy, I know, I do most of the shopping in my family.  But TD Bank wins.  They will use Tyler’s and Claire’s capital earn  money by lending it to someone else at at 4-5%.  They don’t have to worry about inflation because it is not their principal.  The principal belongs to Tyler and Claire!

I think that its better to pay down the mortgage and make your bank hold your available credit in reserve.  Make them hold the money for you rather than the other way around.  If you need it, you’ll pay a little more than the mortgage rate (my HELOC is at 3% compared to my variable rate mortage at 2.1%), but in the meantime, it has reduced your debt, saving you money.

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