Emergency Savings Fund: Why, How Much, and Where?
In a recent post on where to allocate your cash flow, I highlighted that step 1 should be to start an ‘emergency’ savings fund. Starting an emergency savings fund is one of the fundamental building blocks in building a personal finance foundation for yourself. Many personal finance gurus agree that this is one of the first things you should do, ranking ahead of paying off high interest debt. It’s not a flashy topic, but smart personal finance has little to do with flash. This post will cover why you need emergency savings, how much you need, and where to put it.
Why Save for Emergencies?
There are a number of situations that arise in life that you simply do not have control over. Should these situations require immediate cash flow, it is essential to have emergency savings to cover it. If you have a personal investing account or retirement account you could pull funds from these, but for a number of reasons including bad market timing, early withdrawal penalties, or a delay in the liquidity of actually selling your investment and receiving your funds, this is the last thing you want to do.
Having money set aside for emergencies not only prevents this from happening, but also gives you the peace of mind that if something unfortunate was to happen that you will have a little financial cushioning to ride it out.
What Types of Situations May Require Emergency Savings?
I’m sure that you have needed fast cash for a number of situations in your life, or seen situations where others have. Insurance may cover many of these scenarios for you, but there is always a chance that it won’t cover fully what you will need. Here are a few examples:
- lost job or layoff
- began a new job that required you to expense a geographic move
- auto accident, auto retirement, or major repair
- major home expense such as a broken water line, tree falling on your roof, fire, natural disaster effects, etc.
- pet health care
- unexpected taxes owed to IRS
- death in family that required you to help pay for funeral and other expenses
- unexpected medical expenses not fully covered by insurance
How Much do you Need in Emergency Savings?
This is where the experts tend to differ. There are a wide range of guidelines out there for how much you should save. Pick one or a combination, but ultimately, you have to choose an amount that you’re comfortable with and that feels right for you. Here are some of the general guidelines out there:
- 2-3 months worth of take home salary
- 6 months worth of living expenses
- Start small and pay off debt before building 3 to 6 months worth of living expenses. Dave Ramsey falls into this camp. He advocates starting with $1,000, paying off all of your debt, then building a six month emergency fund.
- 8 months worth of living expenses. In the Laws of Money, the Lessons of Life, Suze Orman told readers that the 6 month time frame was no longer enough and that you should have “8 months of cash saved”.
I believe in a combination of the above, with a little twist. I think it is wise to start small and work your way up, as Ramsey recommends, however, I don’t think it’s realistic or wise to pay off ALL of your debt before saving more than $1,000. Focus on paying off high interest debt, but when it comes to school loans and mortgages, paying all of those off first before adding to your emergency savings is not a good idea. Once you’ve paid off high interest debt, then shoot for a minimum of six months of expenses.
Here’s where the twist comes in - if you are anticipating a major life changing event coming up, add to your fund or simply another savings account. You do not want to be pulling from emergency funds to pay off anticipated expenses.
Where Should you Put your Emergency Savings?
You should be earning interest from your savings, otherwise, you are losing value due to the effects of inflation. Place your emergency fund into a high interest savings account, checking account, or money market account (MMA). Stay away from certificates of deposit because if you pull your money out prior to the CD expiring, you will lose interest in the form of a penalty.
Go with a bank that offers quick and easy access to your fund and a competitive rate. Bankrate has a good rate comparison list. Use this as a starting point to see what the current going rate is before committing. At the time of this post, rates look to be around 3%. Check back periodically to see if you’re getting the best going rate. If you’re not, don’t be afraid to switch. If you haven’t already, start building your emergency savings. It will help you sleep better at night.
Reader Questions:
How much do you have in your emergency savings?
What percent to your end goal are you at with your emergency fund?
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I like to keep about $5000 in an HSBC online savings account, but some circumstances that have come up this year have depleted a good portion of the emergency fund. This of course has lead me to believe that at this point in my life I need to have closer to $10,000.
That sounds like a good goal. Past experience is usually a good place to look when figuring out future need. How much is HSBC paying you?
I started building an emergency fund about 6 months ago and have around $3k saved up. I’d like to see that at $10k by the end of this year, I’m working a second job this summer in order to have a little extra income to throw toward that. Currently its sitting in a savings account at USBank, only because that’s where my checking account is set up so I can easily transfer money online. Once I get $4k - $5k I’ll start looking more seriously into money market accounts - I did a small amount of research a few months ago and found that many require $5k to $10k in order to avoid fees, I figured I’d do more extensive research when I have closer to that amount saved.
I don’t exactly have an emergency fund, but I have been putting a good amount into mutual funds outside my 401k. I did this to start saving for a down payment on a house, & mutual funds seem liquid enough to convert into a down payment. Being early in my investing, it seems like overkill to have an emergency fund separate from the funds I’m saving for a down payment.
This article makes a compelling case for having liquid funds available, but I guess I’m not convinced it’d be better to split my non-401K savings between mutual funds & an MMA. Are MFs not liquid enough to handle all of the ‘emergencies’ cited above? It seems almost all those items could be put on a credit card giving you 30 days to convert MF to cash and pay them off without penalty. Yes, market timing may not be ideal to sell the MF, but I don’t see why MMAs are significantly better.
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I got $3000 right now and I am hoping to get it to $6000. It is at ING Direct. I would not worry about interest really this money is not about earnings it is just about a safety net besides there is no place you are going to put it that will yield a high enough interest rate to keep up with inflation and still be liquid. You are going to pay taxes on the interest made and that means if inflation is figured at 6% annually you will have to be around 9% and I have yet to find anything around that, that would allow immediate access to the money without penalty.
Micheal-
The downside to that (depending on your investments in emergency) is not the lack of liquidity (most likely at most 4 business days in your case) but rather “timing risk”. The risk that your water heater/furnace/car/muffy-your-favorite-dog needs a sudden wad of cash thrown at it just as the market decides to shed 3%… I would much rather pull money out of a seperate cash account (savings, mma, etc.) than sell-at-the-bottom (noone gets rich doing that).
Dan-
Thanks for the explanation. Not wanting to sell at a low makes sense, but I still don’t see how that makes cash a superior option. If a mutual fund grows at 10% on avg, but sheds 3% the day before I need to use it as an emergency fund, isn’t that still better than a MMA that grows at 3% overall?
There’s a chance the fund grows less than an MMA over the years it’s sitting in an emergency fund, but from what I understand that seems unlikely. Am I missing something here?
I have $10,000 laddered in four CDs at ING at three month intervals. This way I don’t have to cash in ALL of the emergency fund at one time, and I lose only a bit of interest.
I agree. With these rough financial times, I believe more people are going to realize just how critical it is to have an emergency fund. I also agree with those funds being very liquid with quick easy access. High interest savings accounts may be one of the better options. I’ve been concerned though about the safety of my safety net given the current banking crisis. I was unaware that the FDIC had changed its limits. Then I came across this at my online bank.
FDIC now insures up to $250,000 per depositor. Individual and joint accounts are insured separately, so if you have both types of accounts, your total deposits can be insured up to $500,000; that’s up to $250,000 in all your individual accounts and up to an additional $250,000 in your joint accounts.
source: VentureBankDirect.com/faqs.php
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