One of the worst aspects of an emergency is that you can’t see it coming. We can all expect to face varying degrees of emergencies throughout our lives and preparation is the key to softening the blow. Your personal finances are no exception.
An emergency fund is essentially a cash reserve to handle unforeseen expenses outside your normal budget. These events may include illness, job loss, large repairs (such as car or home expenses), and just about anything else that either reduces your income or increases expenses without prior notice.
How Much Should You Save?
This is a common question and the answer depends a lot on your individual situation. Any amount of reserve is better than nothing and few people save as much as they should. The short answer is that, on average, you should put away 6-9 months on your monthly income as an emergency fund.
Your emergency fund is a safety net designed to protect you from falling into debt. This seems like a large amount but consider the alternatives. A sudden illness or unexpected job loss will affect your ability to earn an income for several months or even longer. Emergencies themselves are emotionally taxing enough without adding unnecessary financial woes.
The trick is taking incremental steps. Focus on first saving a set amount – say a thousand dollars. The average income in America is approximately $48,000/year, so a 9-month emergency fund equates to roughly $36,000. This is a hefty sum to accumulate and the prospect of doing so can seem daunting.
Consider even the worst-case scenario: you create an emergency fund and never need to use it. Your savings are still working for you. By investing in low-risk, high liquidity cash investment options, your savings also become a paycheck (albeit a smaller one compared to higher risk investments).
When to Use Your Savings
This comes back to what you consider to be an emergency. This definition can vary dramatically from person to another. For example, you may see owning a vehicle as a luxury and convenience while someone else may require a vehicle to earn an income.
Is a new car emergency fund worthy? It depends on your situation. Are tickets to a concert coming to town an emergency expense? Probably not. Chances are that once you’ve gone through the painstaking efforts required to establish an emergency fund, you’re less inclined to use it for unnecessary expenses. If you find yourself using your savings on a regular basis though, you may want to reconsider your choices or even your budget.
In order to avoid tapping into your cash reserves prematurely, consider a checks and balance system before making a withdrawal. If you and your spouse or partner share finances make sure you both sign off on emergency expense before making them. For less critical purchases, consider waiting for a predetermined amount of time before making a final decision. These hurdles allow your brain to fully consider the advantages and disadvantages of a purchase without relying solely on initial gut reactions.
NOTE: This trick works well on all expenses, not just emergencies.
If you do have a valid situation where you need additional cash, don’t feel bad about using your emergency fund. That’s what it’s there for! Use your energy to focus on eliminating the emergency before becoming concerned about replenishing the fund itself – better to treat the disease before the symptom.
Ways You SHOULD NOT Invest
Now that you’re starting to amass an emergency fund the next question is where to store it. Fortunately there are several safe products out there that are designed specifically for this reason. There are also several investments you should avoid and we’ll review these in this section.
Stocks, mutual funds, and annuities: While these investments historically return larger yields, they are too volatile for your emergency savings. In general you want to avoid any investments that have the potential of losing value abruptly. The last thing you need to worry about during an emergency is losing your emergency fund as well!
Commodities: Commodities, especially precious metals, have soared in popularity over the past several years following the economic recession. Many brokers have begun preaching the importance of incorporating precious metals into your cash holdings with doomsday-like economic forecasts.
While these arguments sound convincing, you should not include commodities into your emergency fund for the same reason as stocks, they can lose money very quickly and without warning. An emergency fund is not a doomsday fund. If you want to hoard gold and canned tuna in your backyard bunker for the oncoming global financial meltdown, have at it. Just don’t mistake this for an emergency fund.
Fixed properties such as rental homes: Real estate can be a lucrative investment and despite the current housing market situation, it’s generally relatively non-volatile. The main problem here is liquidity or the speed in which you can convert your investment into cash. Emergencies don’t afford us the convenience of time. Selling property takes time, a lot of it as a matter of fact. Your emergency fund should be able to be converted to cash quickly and without a middle-man (real estate agent).
Ways You SHOULD Invest
All the products included herein fall into a class of investing known as “low-risk” and that’s the key. Your emergency fund should be invested in products that highly safe and highly liquid. You will need to sacrifice some liquidity for higher interest-bearing accounts, however in general you should not invest in anything that takes longer than one week to withdrawal from.
The following options are arranged by liquidity and return. Since the two are linked, the higher the liquidity, the less return. All the products included herein fall into a class of investing known as “low-risk” and that’s the key. Most of these products are also guaranteed by the Federal Deposit Insurance Company (FDIC) for up to $250,000. This means that even if the bank itself goes bankrupt, you will not lose any money invested.
Savings Accounts: Chances are you already have one, most banks encourage savings account by offering a small interest payment for monies invested through them. You can withdrawal funds quickly and easily (typically in one business day) and it’s virtually impossible to lose your initial investment. The only way these accounts can lose money is through bank fees so it’s important to make sure you understand the rules that apply with your specific bank to avoid them.
Money Market Accounts: These accounts are very similar to savings accounts with the exception that there are higher restrictions in the frequency you can make withdrawals. Generally though, as long as you are making less than 2 withdrawals a month, this will not be an issue for you. Money Market Accounts (MMAs) offer higher returns than a traditional savings account however you may need to wait 2-5 business days for withdrawals.
Certificates of Deposit (CDs): CDs are ideal for emergency funds but they can take a while to set-up properly. CD returns are directly related to the timeframes they represent. The longer you invest the higher the return. The tricky part is that you cannot collect interest payments until the full-term of the CD is reached. For example; a three-month CD offers an Annual Percentage Yield (APY) of around 0.5% at the time of this writing. In contrast; a five-year CD is offering an APY of around 3%. If you need to make withdrawal before the CD matures, you may lose the interest earned but not the amount you invested. Look into a term called a “CD Ladder” to make the most out of CDs.
Bonds: Bonds come in all forms from Government-backed Treasury Bills (T-Bills) to corporate bonds. Bonds are generally a safe investment but some have the potential of losing value so you should consult with your financial or bank advisor before purchasing. Bonds are also not FDIC insured though some are backed by the state or federal Government for comparable protection. Similar to CDs, bonds are purchased under a set amount of time. Cashing out before these maturity dates can lead to penalties and fees.
Your emergency fund needs to be set up in an account that you do not regularly access for any other reason. The best way to do this is to set up a separate online banking account that you either direct deposit to automatically each month or transfer money to regularly.
While the overall chore of creating an emergency fund can seem overwhelming, the best advice is to simply get started. There’s an old proverb that applies here: “How do you eat an elephant?” The answer is: “One bite at a time”. Focus on the small and you can achieve the large. Start putting money away now and keep looking for ways to increase savings. In time you will have a well-balanced emergency fund that protects you from life’s uncertainties while also creating additional income.