Emergency funds belong in your offset account (or the stock market)

Posted by on 28 February 2019 in Investing & Asset Allocation

If you follow big name financial independence bloggers, you’ll notice that there’s a growing trend advocating we put our emergency fund in the stock market.

The theory is that an emergency fund is for people who don’t have the foresight to manage their money properly. But we’re financial independence enthusiasts, we know what we’re doing.

Although this is correct for most people, we Australians have a unique product that has both the liquidity of a savings accounts and the return of the stock market. It’s the mortgage offset account.

But where’s the best place for our emergency fund? Does the offset account trump the market? And if we don’t have an offset account, can we feel comfortable putting all our money in the stock market?

Why people advocate for an emergency fund

You’ve probably heard it a million times. It’s the cornerstone of every financial plan. Put some money aside in case of emergency.

In Australia’s favourite finance book, The Barefoot Investor, Scott Pape calls it Mojo Money:

The aim of the Mojo account is to get your mojo back, baby. So you don’t have to stress about money like everyone else. It’s for emergencies like, say, your house burning down. And it’s a good feeling knowing that you have a separate pot of money that can be your ‘get out of jail free’ card when you need it.

— Scott Pape, The Barefoot Investor

Emergency fund, mojo money; it’s all the same. It’s the idea that you need to put money aside in case of a catastrophic event. And, God forbid, if something catastrophic actually happens, you have the money to fix the problem without going into debt.

Other bloggers hate emergency funds

You might have stumbled across articles like Our emergency fund is exactly $0.00 and Why an emergency fund is a bad idea in one single chart, and immediately decided to throw your emergency fund into the markets to capture those oh-so-juicy returns.

These articles argue that emergency funds are good for financially irresponsible people. You know these people. These are the people that have never saved money and live paycheck-to-paycheck. For these people, if something goes wrong they literally cannot afford to fix it.

But those article claim that we’re not like that. We’re financially literate, forward thinking, and working towards financial independence. This means two things: firstly, we can be responsible with temporary debt; and secondly, we already have a bunch of fairly liquid assets under out belt in case of emergency.

Apparently having an emergency fund is literally a waste of money. And it’s all because of opportunity cost. That is, the missed opportunity of not putting our money to better use.

Emergency funds can work for Aussies

The implicit assumption in the argument that emergency funds are bad is that money in emergency funds does nothing. It sits in a bank account, accrues minimal interest, and is slowly eroded away by inflation.

But what if there was a way for your money to be generating return but still being completely liquid and also zero risk? There is, and it’s called a mortgage offset account and it’s unique to Australians.

Side note: I don’t think we appreciate how good this actually is! 😮

The great thing about a mortgage offset account is that it’s liquid, it is covered by the Australian Government’s deposit guarantee scheme, it generates a guaranteed return, and that return is tax-free.

For example, assume that you’re overall tax rate is 35% and have an offset account for a mortgage at 4.00% p.a. interest. Any money that you put into this account will generate returns at a guaranteed effective interest rate of 6.15%. No risk, no fluctuations, take your money back for free at any time.

What does the data say?

The question then becomes should we put our money in an offset account or are we still better off putting that money into the stock market? Let’s test this using historical simulations.

Fortunately, we have market returns data from our work on Safe Withdrawal Rates, and the Reserve Bank of Australia shares data on mortgage and deposit interest rates. For our simulation, we will use:

  1. Market returns for a portfolio split 50/50 between an Australian stock market index fund and a U.S. stock market index fund
  2. Retail deposit interest rates for online savings accounts
  3. Discounted variable interest rates for owner-occupied loans

The chart above shows the real (i.e. inflation-adjusted returns) for each investment type over the period 2004-17. Unfortunately, the RBA doesn’t publish the full data set prior to 2004.

As we would expect, returns for deposits and mortgage offset accounts are relatively stable and trend slightly downwards as interest rates have fallen. In fact, after accounting for inflation, deposits starting returning less than 0% in 2017. This means that we’re effectively losing money by keeping it in a so-called ‘high interest’ online savings account.

Stock market returns are highly volatile over the period and we can see a big negative return in 2008 thanks to the big, bad Global Financial Crisis.

In the chart above we have plotted the total return of $10,000 invested in each of the investment options in 2003. There’s a few things to keep in mind:

  • Returns calculated on the offset account assume that we refinance to the RBA’s average discount variable rate for owner-occupied loans on a yearly basis. The consequence of this assumption is that we most likely underestimate the return on an offset account because the period of 2003-17 is a broadly falling interest rate environment in Australia (although this will be partly offset by refinance costs). The net benefit of refinancing and investing the difference in the stock market is something we can save for another post.
  • Stock market returns include an expense ratio of 0.16%, which is the actual weighted cost of the equivalent Vanguard ETFs. The U.S. portion of the portfolio is includes foreign exchange fluctuations.
  • We assume no fees for high interest savings account returns.

As you can see, after 14 years the value of $10,000 would have grown to $25,793 if invested in the stock market and $22,013 if left in the offset account. The online savings account would have grown to a disappointing $12,323.

Now a word of warning! We need to be conscious of sequence of returns risk for an emergency fund invested in the market. In the example above, we experience significant negative returns early in the investment period, so it doesn’t affect the final portfolio balance too much. But if we had that -38% return at the the end of the 14 year period, the final balance wouldn’t be quite so high!

But that’s not the whole story. Interest earned on deposits and stock market capital gains are taxed at your marginal tax rate, minus the capital gains discount if applicable. So these investments can be subject to some pretty hefty tax bills.

Funds invested in an offset account are effectively tax-free. This is because they don’t result in a gain as such, they result in the avoidance of a loss. The chart above illustrates the tax benefit of funds in an offset account for a hypothetical individual with a blended tax rate of 35%.

Compared to the high interest savings account, there is some tax benefit to investing the stock market. For any shares held for over one year, we are eligible to reduce the capital gains tax by 50%. But that’s nothing compared to the tax-free treatment of the offset account. 

In the pre-tax scenario the market outperforms the offset account by ~$3,500, but in the post-tax scenario the offset account outperforms the market by ~$1,100. Take the exact dollar values with a grain of salt, as tax benefits are highly dependent on individual circumstances. But suffice to say that there’s a significant tax benefit of investing funds in the offset account.

Is it wrong to invest your emergency fund in the market?

Some people either don’t have a mortgage or feel more comfortable investing their money in the market to avoid cash drag (i.e. the lost opportunity due to not investing our cash in the market).

The biggest complaint from those who advocate for emergency funds is this: “I can’t put my money in the stock market, what if I have an emergency and my stocks are performing poorly? I’ll lock in the losses!”.

But we forget that there are two types of emergencies:

Emergency Type 1: Random

One type of emergency occurs randomly, like your plumbing getting clogged and flooding your house, or somebody crashing into your car.

If you’re already racing to financial independence, it’s likely that you’re saving a significant proportion of your income every month. In reality, if you’ve saving a few thousand dollars a month, you can probably cover most minor emergencies with this money.

Also, these events are not correlated with periods of sustained poor share market performance. So most often we can comfortably sell part of the emergency fund in the stock market without locking in any significant loss. ETFs are highly liquid and it’s very simple to sell a portion of our portfolio to cover emergency events.

Emergency Type 2: Correlated with poor market performance

The second type of emergency isn’t so random, like losing your job during an economic downturn. This could very well occur at a period of poor stock market performance and this is the one we need to worry about.

We always have the option to temporarily use a credit card to pay for the emergency and maintain cash flow. As long as we’re sensible enough to pay off the balance before we start accruing interest, then it’s a reasonable strategy.

If that doesn’t cover the expenses, then we may have to sell some ETFs. But that’s ok! In most cases, we will have owned those ETFs for long enough to have made a decent return.

If we haven’t made a return on investment yet and we have an emergency like this, then it’s simply very unluckly. The timing was horrible!

The argument here isn’t that investing your emergency fund in the stock market is always going to be more beneficial than in cash, but it will be better on average. Sometimes the cards don’t fall right and it doesn’t quite work out.

Just remember, there’s a difference between a bad decision (leaving our emergency fund in a bank account) and a good decision that may, in some rare cases, result in a bad outcome (investing our emergency fund in the stock market).

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There are 7 comments on this article

  1. Avatar for Dan Montgomery

    Aussie HIFIRE

    An interesting analysis Dan. I’d agree that using an offset account rather than a HISA is absolutely a no brainer, higher return and zero tax makes this the obvious choice. However if you don’t have a mortgage then your choice is between a HISA and putting it in the market, and of these two options I would advocate the former.
    I want an emergency fund to give me easy access to cash for whatever purpose I need it for. I don’t want to be worrying about what the market is doing, I don’t want to be thinking about what CGT I might have to pay, I don’t want to potentially be selling shares at a loss, I want cold hard cash right there and then with no delays. I understand that I’ll be paying some tax on the earnings but that won’t be that high anyway, and in any case that’s a pretty low price to pay for the certainty of knowing that I can get access to the money when I need it.
    This is particularly important with the second situation you’re talking about where you lose your job during an economic downturn. The last thing I want is to have no income from work AND have to sell more of my shares because they’re worth less in order to cover my living expenses.
    I’m not worried about the upside I’m missing out on, I’m focussed on the downside I’m preventing or mitigating by having cash available when I need it. Sure there is an opportunity cost but I’m more than happy to pay it.

    • Avatar for Dan Montgomery

      J.D.

      Agree with this.
      Although I found it a little unusual that “the market” was not clearly separate into equities and bonds. I think investing an emergency fund in “the market” might be ok if it was the bonds part of the market. Unfortunately for many Aussies, “the market” usually means 100% equities and that definitely is not the place for an emergency fund for those that have no property they can extract equity out of to use in an emergency.

      • Avatar for Dan Montgomery

        Dan Montgomery

        Thanks guys. I agree with the offset account feels like the best place to put an emergency fund. For me, the tax benefits get it over the line.

        The big question mark seems to be for people that don’t have a mortgage and offset account. I think there’s a legitimate case for investing that money in the market. Despite the volatility, in most cases the investment will have returned well enough to not lock-in losses.

        The trick with bonds is that they reduce cash drag (although they have their own ‘bond drag’ compared to stocks), however, they are still somewhat volatile and there’s still a risk that we lock-in bond losses. I think I’ll focus on this in the next post.

        • Avatar for Dan Montgomery

          Aussie HIFIRE

          I think for me I want to be looking at the purpose of the emergency fund first and then the performance afterwards. The purpose is to give me no questions asked access straight away, performance is very much secondary to that. Even if it came down to a choice of no interest in a bank account vs share market returns, I’d go with the no interest account. I want the money to be there, not be worrying about whether there is enough or not. This would be particularly true when you’re in the early stages of investing and don’t have much in the way of other investments you could potentially sell down.

          • Avatar for Dan Montgomery

            Dan Montgomery

            I see what you’re saying mate. I have a hypothesis that people actually overestimate risk in the market. It’s rare for the market to drop more than 40%, which means that you’d need an emergency that requires 60%+ of your emergency fund to potentially run out of funds. I’ll do some historical simulations to test this 🙂

  2. Avatar for Dan Montgomery

    Laplace

    Great read, thanks for that.
    Does this apply to a redraw as well?

    Cheers

    • Avatar for Dan Montgomery

      J.D.

      I don’t see how this applies to a redraw.
      Paying money into a redraw is considered paying the loan down, and when you take it out, for tax purposes, it is considered to be borrowing new money.
      Borrowing new money to pay for non-investment expenses will result in interest on that borrowed portion not being tax deductible.
      Better to use an offset – when you put money in, it is still legally your own money so you can take it out again to use for anything (including non-investment purposes) and there are no issues.

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