If our lives always went according to plan, we would never be hit with expensive car repairs, sudden job layoffs, family emergencies, or unexpected health problems. But these curveballs are simply part of life, and if you’ve ever been caught off guard for one of them, you know how important an emergency fund can be.
Most of us can agree having extra money set aside to deal with life’s rough patches is a good thing, but not everyone agrees on the specifics. It’s hard to see a downside to saving as much as possible, but here are some key tactics to keep in mind.
My Emergency Fund Story
I quickly learned the importance of an emergency fund after burning out in my previous career. Five years of promoting concerts throughout North America had taken its toll, and I knew I needed a break to recharge. But working in the music business also led to excessive spending on designer clothing, fancy dinners, and too much partying—leaving little savings to show for my hard work. So I drastically cut back, saving 40-50% of everything I earned, until I had finally socked away six-months of my take-home pay. My six-month emergency fund gave me the confidence to quit my job and recharge for a few months before eventually transitioning into tech.
How Much Emergency Fund Do You Need?
Experts recommend saving three to six months of your take-home pay in liquid assets for your emergency fund. But if you’re properly insured, a smaller amount may be sufficient. It’s also important to consider your existing level of liability. Ultimately, your individual circumstances will determine how much you need.
Ask yourself these important questions during the decision making process:
- Does your employer or union provide a loss of income protection plan like short or long-term disability insurance?
- What are the withdrawal terms on your permanent life insurance policy?
- How robust is your medical insurance plan?
- What is your existing level of fixed expenses and debt? You should certainly still have an emergency fund of at least $1,000 if you’re dealing with debt.
- Does your family have additional sources of income?
- Do you have access to a home equity line of credit?
Although saving too much is never a bad thing, it’s definitely possible to hold onto too much cash. Be aware that inflation eats away at the value of your cash over time. Also, there’s an opportunity cost when holding too much cash in low-return investments as opposed to investing some of those funds.
Tactics To Quickly Build an Emergency Fund
One of the fastest ways to build an emergency fund is by automating your savings. If a certain amount is deducted from every paycheck, you will never have the opportunity to spend that money earmarked for savings on payday cocktails. There are a couple of ways to set this up:
- Speak with your company’s HR department about automatically deducting a certain amount of money from every paycheck and depositing it into your savings account.
- Ask your bank to automatically transfer a fixed amount from your checking account to your savings account every month.
Even $25 or $50 a month accumulates more quickly than you might think. Remember, you won’t be able to spend what’s not available. Money market mutual funds, asset management accounts, and series EE savings bonds all work well for automated savings plans.
Allocation of Your Emergency Fund Assets
The Importance of Liquidity
Most financial advisors emphasize the importance of maintaining adequate liquidity with your emergency fund. Liquidity means having easy access to cash, without needing to dip into your long-term investments, in order to pay your bills on time.
Although I saved the recommended six months of take-home pay, I didn’t hold an adequate amount in cash. After two months without a full-time job, I was forced to sell some stocks to cover my expenses—a move that can cause a loss of principal or tax liability.
A misallocated emergency fund certainly isn’t the worst financial problem you can have. But given the choice, you’d probably prefer not to be forced to sell off your assets when they’ve declined in value.
Where To Allocate Your Assets
There’s a lot to consider when you begin thinking about where to stash your emergency fund assets. For starters, you’ll want to consider your own risk tolerance. Next, you’ll need to evaluate each option’s rate of return. This isn’t always easy to compare because compounding interest rates are quoted at different periods (annually, quarterly, or even daily). You’ll also want to think about the tax implications of these allocations. A financial planner or accountant can help with specific tax questions you may have.
Here’s a breakdown of your options:
Checking account: They are convenient, easy to use, and FDIC insured. They generally require a low minimum balance, but some accounts can incur costly fees. The primary downside is no or low interest rates. If you’re using a checking account that keeps dinging you with fees, then it’s time to switch.
Savings Account: They are FDIC insured up to $250,000 and have higher interest rates than a checking account. In some cases the interest rates can be above 1.00% APY. However, the return is still considered low compared to the alternatives. Savings accounts aren’t as liquid as a checking account as it can take a day or more to access the funds depending on your bank.
Money Market Deposit Account: These accounts are insured, have limited checking privileges, and offer relatively attractive (variable) interest rates. However, they still offer lower returns than CDs and money market mutual funds. They also require a high minimum balance.
Certificate of Deposit (CD): CDs are insured, but interest rates are fixed, so you won’t benefit if rates go up. There’s a minimum required deposit and there are penalties for early withdrawal.
Money Market Mutual Fund: These funds work well for an automated payroll deduction plan and offer some checking privileges. There’s limited risk due to the short maturity of the investments, but they are not insured. The minimum initial balance is generally between $500 and $1,000.
Asset Management Account: This account also works well with an automated payroll deduction plan and offers a high return. However, these accounts aren’t insured and require a high minimum balance of $5,000. Additionally, these accounts have monthly fees that range from $25 to $200.
U.S. Treasury Bills: These offer attractive interest rates, are exempt from state and local taxes, and guaranteed by the Federal government. However, they are far less convenient to liquidate than the other options.
U.S. Series EE Bonds: Depending on when they are purchased, the interest rate can be fixed or variable. They can purchased and redeemed at any bank and work well with automated payroll deduction plans. They are exempt from local and state taxes. Interest only accrues twice per year, and there’s a penalty if you redeem before five years.
Regardless of the amount and the allocation you choose, an emergency fund is critical for your long-term financial health. In a perfect world, you’d never have to use it, but you’ll sleep much better at night knowing you’re covered if a disaster strikes.