Borrow From Yourself!

The cheapest lender is usually... you

We all get 'cash crunches' -- times of higher-than-usual expense, when outgoings might temporarily exceed income. Expenses like a repair bill, for example, or a sudden need for a new washing machine, or even the annual car insurance premium. And being self-employed, with young-ish children, I suspect I'm more exposed than most to erratic cash inflows and outflows.

Faced with an urgent need pay out cash in such situations, many people stick it on a credit card, go overdrawn, or -- horrors! -- write a credit card cheque. I've done all three myself. Increasingly, though, these days I borrow from a much cheaper lender: me.

I've been a Fool for nearly seven years now and in that time I've seen innumerable posters on our Dealing With Debt and Living Below Your Means boards sing the praises of having an emergency fund. The trouble is, sticking cash aside for an emergency fund can be tricky, especially if your income is already stretched to the limit.

And taking money out of long-term savings (if you have some) is equally tricky. If you take cash out of your Cash ISA, you cannot pay the money back in during that tax year once you have paid in the annual contribution limit for the year (currently £3000 for a Cash Isa.)

I've found two ways of getting the advantages of an emergency fund without necessarily having one to hand when unexpected bills come in.

First, although I make regular monthly payments into a FTSE All Share index tracker ISA, I top up these payments at the end of the tax year when my ISA allowance is about to expire. These one-off lump sum payments, of sometimes several thousand pounds, accumulate during the year in a building society savings account, linked to a rarely-used current account. The cash going into the savings account arrives there irregularly, and comes from a variety of sources -- including taxed earnings from a second job -- but it's all money that is ring-fenced for the annual ISA top-up.

While it's in the account, though, I can use it to cover short-term cash crunches -- providing that I am ruthlessly scrupulous about paying it back. (In all the time I've done this, I've never failed to pay the money back, at most borrowing it for three weeks or so.)

With a phone call to the building society, the money is transferred from the savings account to the current account, a cheque is written and my short-term cash problem vanishes. In effect, by not paying my money into the index tracker ISA straight away, I'm giving myself some useful flexibility when it comes to cash crunches.

Now, while this system works, it's not perfect. By definition, at the start of the tax year there won't be any money in the savings account -- because it's all been transferred into the index tracker ISA. Which is where another little pool of cash comes in handy.

Some of my self-employed trading activity goes though a limited company. Borrowing from a limited company has an income tax liability if the loan crosses the end of the accounting year. To avoid that, the money must be paid back. This means I have a strong incentive to put the money back promptly -- just as when I borrow money that I have earmarked for my ISA.

So once again, the net result is ready access to short-term funds, without needing to charge the expense to a credit card, or pay a bank interest. Sure, by taking the money out I'm losing interest that I would have earned -- but this is cheaper than paying a higher rate of interest to a third party. Plus, the psychology is different: I'm far more scrupulous about paying it back than if I'd just stuck the bill on a credit card.

Will either of these tricks work for you? I don't know. What I do know is that they work for me. And here's the odd thing. A couple of years back, prompted by once again reading about emergency funds on The Fool, I opened a savings account and set up a proper emergency fund into which I pay £50 each month.

But somehow, I can't bear to take money out of it -- I just love watching the monthly balance continually go up! On the other hand, it's comforting to know that if an emergency arose that was beyond the means of my two other sources of cash, I'd have a third pool of cash there as a back-up.

To make sure your emergency savings are earning the best rate of interest, visit The Fool's savings centre.

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