A Comprehensive Guide to Emergency Savings
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 Should you Put 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. The 4 online banks with a wide variety of product offerings and the highest savings yields are usually Discover Bank, Ally, Penfed, and Capital One 360. These banks still offer free checking accounts and debit cards. Use this as a starting point to see what the current going rate is before committing. 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.
There is also a case for putting your emergency savings in an ETF with a discount online brokerage. If you need to access the funds, you can have them within a few days via a bank transfer (and use credit cards in the meantime, which buys you time). The caveat with this is that if the market declines, you must replenish your base amount.
Emergency Savings Discussion
- 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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