If you’re a fan of Dave Ramsey, you’re very familiar with Baby Steps 1 and 3, both of which relate to building an emergency fund. I also recommend starting your financial journey by funding your emergency fund. If you’d like more information on how to prioritize your savings order, check out my colleague’s comprehensive article on that here.
So why do you need an emergency fund? How much should you set aside? Where should you put that money? These are all questions each person should ask themselves.
Why Do I Need Emergency Savings?
Ok, I’m being a bit flippant here, but when the skies are blue it’s easy for us to forget that sometimes it rains (or snows, in Utah’s case).
I’ll give you an example. At the end of 2022, my wife and I noticed that we had a puddle of water next to our cabinets. That’s not unusual for my house—I have 3 young girls, so something spilled on the floor is par for the course. But this was the puddle’s second appearance of the morning. So, we decided to check out the basement right below that spot and discovered this unfortunate bubble in our ceiling.
Apparently, a mouse snuck its way into the space between our main floor and basement ceiling and decided to make a snack of our poorly located dishwasher drainage line. Fortunately, insurance covered the cleanup, damage, and repairs. However, it did not cover the plumber, dishwasher repair and subsequent dishwasher replacement. It also just so happens that at the same time, both my mechanic and my wife advised me that it was time to replace my car. Apparently, working A/C is important. Oh, and my neighbor wanted to put up a new fence and asked me to pay half. And it was time for our 90’s ragged carpet to get an update. And my garage door just broke…
I recognize that some of these aren’t actual emergencies. But the point is, you cannot predict life’s random events. An emergency stash is absolutely necessary to help you when everything goes wrong.
How Much Do I Need?
A quick Google search will reveal the popular rule of thumb: 3-6 months’ worth of living expenses. I mostly agree that is a great range that will probably suffice for many people, but it’s oversimplified. You might have a unique situation that warrants more or less than 3-6 months. Here are just a few factors that might require you to deviate from the norm:
- Single vs dual income household
- Family size
- Stability of income
- Source of income
- Startup business needs
Honestly, I could probably make this list pages long. The point is every situation is unique and you should carefully look at your situation when deciding how much is enough. At Squire Wealth Advisors we’ve developed a helpful one-pager for determining your emergency savings needs. You can access it here.
Where Do I Put It?
Now, I need to be careful here. This does not constitute specific advice for those reading this article. Your situation is specific to you and these recommendations will be ideas to consider, but please consider your unique situation and consult your financial advisor before deciding. The best emergency funds are liquid, easily accessible, and insulated from market fluctuations.
Under Your Mattress
Holding onto physical cash for your emergency fund is not recommended. Over time, inflation will gobble that all up. What used to fit under a king, will now fit under a crib. However, it’s wise to keep some cash in a safe place when you can’t access a bank in the case of a really dire emergency. I usually keep about $500 in cash that could be used to transport and feed my family if something significant were to happen like a fire, flood, or earthquake.
- Loss of buying power
Probably the most common place to keep your rainy-day fund. You can keep extra in your normal checking account, but I recommend a separate account so you’re not tempted to spend it on that 8-day Mediterranean cruise coming up next month to celebrate your 10-year anniversary. Oddly specific? Yes. You live and you learn!
- Low interest
- Maybe too accessible
Money Market Account
Not to be confused with Money Market Mutual Funds, money market accounts are interest-bearing accounts held at a bank or credit union. They will typically offer a higher interest rate than a savings account, but the interest rate can be variable and rise or fall with market conditions.1
- Limited transactions
- Minimum balance requirement
Certificate of Deposit (CD)
A CD is an interest-bearing product you can purchase at a bank or credit union. They differ from a savings account because the money must remain untouched for a specified period or you risk paying fees. They will typically offer a higher interest rate than a savings account.2
- Less liquid
- Early withdrawal penalty fees
High-Yield Savings Account
A high-yield savings account is very similar to a regular savings account, but typically they are housed at online banks, which can pass on their lower overhead costs to you in the form of higher interest rates. They typically offer higher interest rates than traditional savings accounts, but less than a CD. However, they are more liquid than a CD.
- Online only, typically
- Can limit you to a certain # of transactions per month
Investment Brokerage Account
An investment brokerage account is a type of account that allows you to invest the cash you have deposited into it. The account itself is really not different than any other type of taxable account, with the exception that you can invest your money and don’t have to leave it in cash. This is where you could purchase money market mutual funds, stocks, or bonds. You can set up a brokerage account at brokers like Charles Schwab, Fidelity, and Vanguard. The pros and cons of a brokerage account depend upon what you do with the cash you put into it.
Leave It In Cash
This is no different than putting it under your mattress. Inflation will reduce your buying power.
Purchase Money Market Mutual Funds
This is a type of mutual fund that invests in debt securities with short maturities and minimal credit risk. These are among the lowest-volatility types of investments.3
- Not FDIC insured
- While very low risk, still not completely insulated from market fluctuations
Purchase Stocks, Bonds, or Treasuries
It’s possible to take your emergency stash in the investment brokerage account and purchase securities like mutual funds, ETF’s, stocks, or bonds. This might generate you better returns, but the volatility and potential loss of value mean it doesn’t possess one of the three most important elements of an emergency fund, insulation from market fluctuations.
- Market fluctuation
- Relative lack of liquidity, particularly if the value of the funds are down
Don’t skip those baby steps to building your emergency savings. And as you are determining the amount to stash away, carefully consider your specific needs and put the money somewhere that is liquid, easily accessible, and insulated from market fluctuations.