This piece is based on an article from my colleague Christine Benz and adapted for Australian audiences.

Whenever I get asked about what to invest in, my first question is always whether they have an emergency fund set up before they start. An emergency fund isn’t as exciting as placing your first trade, but it is one of the most important pillars of successful investing.

An emergency fund is a pool of savings that serves as insurance for the unexpected - job loss, unexpected medical bills, car repairs. Emergencies rarely arrive at convenient times. Having cash accessible prevents short-term problems from having long-term financial consequences.

Sometimes emergencies will exceed even well-stocked reserves. Research from Morningstar’s behavioural research team has found that most investors, including high net worth investors, do not have an adequate emergency fund.

What happens when you exhaust your emergency fund? Where should you turn? To understand where you should draw funds from first, you must look at the cost of ‘borrowing’ from that asset. Below is a hierarchy of funding options ranked broadly from least costly and disruptive to most for your long-term outcomes.

Importantly, it assumes that you are not recuperating the funds immediately and will require a decent stint (3-5 years) to save the funds and recuperate your emergency fund. The order will change based on the time needed to recover your funds.

1. Your emergency fund or cash accounts

Typical opportunity cost: 4-5% p.a.

The first line of defence should always be your emergency fund. These reserves should be held in highly liquid assets such as a high-interest savings account. This means that the real cost of using the money is simply the opportunity cost of foregoing this interest.

The guide for an emergency fund is 4-6 months worth of living expenses for salaried households, one year worth of expenses for self-employed households and 1-3 years of living expenses for retired individuals.

Using these funds has no tax consequences and does not involve borrowing costs.

2. Mortgage redraw or offset cost

Typical opportunity cost: 5.5% - 6.5%

Many Australian homeowners effectively hold an emergency fund within their mortgage. This could be through an offset account or a redraw facility. Accessing these funds from these sources effectively means borrowing at your mortgage rate, which sits between 5.5% and 6.5% for many borrowers.

This is a popular choice for Australians right now. Balances in offset accounts have increased to 11% of the credit limits. This is the highest amount since APRA started collecting this data.

The advantage of offset accounts is the cost of this source of funds. Mortgage rates are usually far lower than other forms of borrowing, making them one of the most efficient ways to raise emergency liquidity. Although the typical opportunity cost is higher than the return earned by low-risk investments in taxable accounts, there’s no extra capital gains to consider.

3. Low-risk investments in taxable accounts

Typical cost: capital gains tax + lost future returns

If your emergency fund is depleted, your next port of call should be investments held outside of superannuation. The opportunity cost is:

  • Capital Gains Tax (CGT) if the assets have increased in value
  • Any transaction costs or brokerage
  • Any lost future earnings

The CGT discount for assets held longer than 12 months can lower the effective tax burden. Selling assets that have declined in value could generate a capital loss which may offset future gains.

From a planning perspective, it may make sense to sell:

  • Investments with small gains
  • Investments sitting on tax losses
  • Defensive assets like fixed income ETFs or funds.

These options can still disrupt a portfolio, but may be cheaper than borrowing over the long-term. If the capital gains in these assets are small and the assets are income based, this may have a lower opportunity cost than offset accounts.

4. Reverse mortgages (for retirees)

Typical hurdle rate: 7–9% p.a.

Older Australians with substantial home equity may consider a reverse mortgage. These products allow pre-retiree or retiree homeowners to borrow against their home without making repayments until the property is sold. The interest rates are currently around 7-9%, with the interest compounding over time.

The advantages to this is that there are no immediate repayments with access to home equity. The downsides are significant – compounding of debt and reduced inheritance which is important to many retirees.

Reverse mortgages should be considered later in the hierarchy as they reduce the financial flexibility of retirees.

5. Early access to superannuation

Typical opportunity cost: 17-22% and lost future returns

The superannuation system discourages early withdrawals. It is difficult to access funds before preservation age. However, severe financial hardship or compassionate grounds allow you to access your funds prior to retirement. The cost is high. You lose tax-advantaged compounding, permanent reduction in retirement savings, and you must pay tax upon exit – between 17 and 22%.

For younger investors, the cost is much higher than the tax rate charged. It also includes the lost compounding over decades that could be a meaningful difference to your outcomes.

If you are a retiree with free access to superannuation, the opportunity cost is much lower and would be higher up the hierarchy. Although the typical opportunity cost is higher than personal loans, it is not a compounding debt that can cost more over the long term.

6. Personal loans

Typical opportunity cost: 9-14% p.a.

Unsecured personal loans are widely available in Australia but come with higher interest rates.

Typical rates are between 9-14%, depending on creditworthiness. These loans can provide quick access to funds, but the cost of servicing them can quickly snowball with a high interest rate. This option would be further up the list if it was a shorter time frame. Many investors would be served better by a shorter-term personal loan than partaking in a reverse mortgage, or early access to superannuation.

7. Margin loans against investments

Typical opportunity cost: 8-11% p.a.

Investors with substantial portfolios may be able to borrow against their holdings through a margin loan. Typical Australian margin loan rates current sit around 8-11%, depending on the lender and the portfolio size. The attraction is that investors can access liquidity without selling investments and triggering capital gains tax.

However, the risks are significant. The investments serve as collateral, market declines may trigger margin calls and investors could be forced to sell assets at the worst possible time.

For financially stable investors needing short-term liquidity, this may be an option. For investors already under financial pressure, this could cause further issues.

8. Credit cards

Typical hurdle rate: 18-22% p.a.

Credit cards are usually the most expensive form of borrowing available to consumers. Standard rates sit between 18-22% and minimum repayments often prolong the debt for years.

The average Australian holds almost $25,000 in consumer debt – this is excluding student loans and home loans. $2,800 of this is carried on credit cards.

If you have a $3,000 credit card balance with an interest rate of 20% p.a. and only make the minimum payments per month, you end up paying $14,168 for those initial purchases.

Credit cards often offer short-term relief with promotional balance transfers, but relying on credit cards over long time periods for emergency funding is severely detrimental to future outcomes and can cause long-term financial strain.

Final thoughts

There are a lot of assumptions underlying this hierarchy. If you need a stop gap solution, credit cards can often give you 45 days of breathing room if you have certainty of income to pay off your funds.

If you need a much longer period to recover the funds, you may consider early access to superannuation over a personal loan, but a shorter time period may mean the other way around.

If you have a small gap between what your emergency fund can cover and what your emergency requires, your offset may be at the top of the hierarchy. This hierarchy will change dependent on your situation and your actual opportunity costs but always think about the long term opportunity cost to understand what the right choice is. This should include lost compounding, tax and costs.

What’s important to remember is that the cost of accessing money rises dramatically once investors move beyond their own savings. What may begin as a poorly timed inconvenience can quickly become a financial drag that incurs high interest costs, taxes or lost investment growth. If you are reading this pre-emptively, it may be the right time to ensure that you have an adequate emergency fund. It will not generate the highest returns, but it will stop your financial security collapsing or having to make expensive choices that impact your financial future.

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