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rule #1Do not use a home equity line of credit as a substitute for cash reserves.
I am a firm believer in cash reserves. Except for participating in a company retirement plan, you should not begin to invest in stocks, bonds, mutual funds, real estate, or any other asset class until you first set aside some money as cash reserves.1
The amount you need in reserves is based on how much money you spend (not on what you earn) and on the stability of your income (not the income itself). For example, because my clients Richard and Catherine are married2 and each have secure jobs, two months' worth of spending is probably sufficient. However, another client, June, a single mom who earns sales commissions, ought to keep 12 months' worth of spending in cash reserves. The point is that every person or family should maintain in cash reserves enough to get through those unexpected but inevitable rough times.
As important as that is, it's equally important that you maintain only enough in reserves, because the interest rate your reserves will earn is terribly low--lower, in fact, than what you'll earn on virtually any other investment.
Once you determine how much you need for reserves, you must keep your reserves safe (meaning you cannot lose this money) and liquid (meaning you can get to it at any time without penalty). Only six places qualify: Your mattress, savings accounts, checking accounts, money market funds, U.S. Treasury bills, and short-term bank CDs.
Although most folks who are attentive to their finances agree with this concept, over the past several years, many have become unhappy with the idea of stashing $15,000 or $20,000 into low-interest bank accounts, wherethe money just sits for a rainy day that might never come, while their investments in stocks and mutual funds have been earning 15% a year or more.
Increasingly, I have come across people who are not maintaining any money in cash reserves. Instead, they're taking out home equity lines of credit at the bank.
It's a great idea, they say. Because they bought their houses many years ago, they now have substantial equity in their homes, enabling them to obtain a $20,000 or sometimes even a $50,000 line of credit. This way, they tell me, they can fully invest all their cash and, if the roof suddenly needs repairs, they can simply draw against the credit line to pay the bill. Besides, they argue, I want them to carry a big, long mortgage anyway, right?3
Yes, I do want them to get a big, long mortgage,4 but their attempt to use that point in this conversation is obfuscation.5
Although their plan sounds good, it is predicated on two things: Good performance from their investments and a short-lived, although not necessarily inexpensive, crisis. I'm not sure I'd categorize a new roof as an economic crisis (at least, it shouldn't be one). No, in my opinion, a real crisis would be you losing your job because your company went broke--rendering worthless all of your company stock and tying up in litigation your 401(k) plan because the company owner was stealing from it in a vain attempt to keep the company afloat.6
That's what happened to a client of mine. He lost his job when his company went broke, and fearing that he might be out of work for months, he went to the bank to seek an increase in his credit line. When asked why he wanted the increase, he replied to the loan officer, "Well, I've just lost my job, so I want this to help tide me over."
Bad move. Not only did they deny his request, the bank canceled his existing credit line!7
Remember, it's called cash reserves for a reason. So, while you can be as clever as you want when it comes to selecting your investments, don't get too creative when it comes to building and maintaining your cash reserves. Because when that crisis hits, you'll agree: There is no substitute for cash.
rule #2Never pick the money fund offering higher rates than everyone else.
Since lines of credit are not acceptable for cash reserves (see previous Rule), you have no choice but to stash some cash away for that rainy day. A natural tendency is to put the cash into the highest-yielding account you can find.
Money market funds are a good choice, because they don't charge fees, they offer free check-writing privileges, and they pay interest rates that usually are a little higher than what banks offer. But you must no longer choose the money fund that is offering the highest rate, and if that's where your money already is, get it out now.
Money market funds, like all mutual funds, give you shares when you make a deposit. But unlike mutual funds, where share prices change daily, money market share prices are always $1, and they do not fluctuate. At least, they're not supposed to. They maintain consistency by investing in short-term (30-day) U.S. Treasury bills or "commercial paper," which are like T-bills except that they're issued by corporations instead of the federal government.
Say you saw ads in the newspaper for two money market funds. One offers a rate of 4.3%, while the other offers 4.7%. Which would you buy?
In a world where the greater the return, the greater the risk, you might anticipate that the fund offering the higher yield must be doing something to get that higher return. And you'd be right: Funds that offer higher returns invest in higher-risk securities.
Just ask the people at Strong Capital Management, one of the largest mutual fund companies in America. They offer the Strong Institutional Money Market Fund. To attract investors, they offered a higher interest rate than other money funds. To get that rate, though, they invested in riskier investments. And when one of those investments lost 85% of its value, Strong's money market fund ran the risk of falling below $1 per share.
This would have been a momentous occurrence, something that technically has never happened. Many say it never will.8 But Wall Street has a name for it anyway. It's called "breaking the buck." The fear is that if someone breaks the buck in the money market fund business, the ensuing panic would have incredible repercussions throughout the investment community. After all, most people think money market funds are as safe as bank accounts, and if that perception were broken, millions of investors would withdraw their money, creating a "run" on the funds like we once saw in banks.
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