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If we learned anything from 2020, it’s that it’s a good idea to prepare for the unexpected. This is especially true when it comes to finances. An emergency fund can help ensure that an unexpected expense or sudden job loss doesn’t derail you completely. It’s designed to provide a cushion and buy some time so you can adjust your budget or take other tactics to navigate an unexpected financial crisis.
A common question that comes up is “How much should you have saved up in your emergency fund?” The answer is, it depends on your income and necessary expenses. In general, it’s recommended to have at least three to six months’ worth of expenses set aside.
If you have a very stable job, you may be able to lean toward the shorter end of the spectrum, but those with variable incomes or minor dependents may want to have the full six months’ worth, or more if possible. Some people consider all regular expenses when totaling up their monthly expenses, while others only count absolutely necessary costs such as food, shelter and utilities.
So, where should you keep your emergency fund? The general principle is to keep it somewhere you can get to easily but separate from the rest of your finances so you’re not tempted to dip into it.
Your emergency fund needs to be easily reachable
Your emergency fund doesn’t help you if you can’t actually access the funds quickly when you need to. For this reason, your emergency fund should be liquid, which means easily accessible in cash. You don’t want to have to worry about withdrawing from complicated investments—often with a penalty—or having to sell something to get the money when you need it.
However, you also need the money to be safe. Cash under the mattress isn’t the best idea, and this also rules out risky investments like stocks.
What are the best places for emergency funds?
The best place for an emergency fund, which is different from a sinking fund, is a bank or credit union account that’s easy to access, doesn’t charge a lot of fees and still gives you interest on your money. Most financial institutions offer a variety of accounts, so you’ll want to compare terms such as interest rates, monthly fees and any penalties for withdrawing.
Money market accounts
A money market account is one of the more common options for where to keep your emergency fund. Almost all banks offer them, and rates vary but are usually low. The average at the end of 2020 was around 0.07 percent.
Money market accounts are a great option for an emergency fund because they usually come with debit cards or checks so you can easily access the money when you need to spend it, and there are often fewer limitations or restrictions on things such as how many transactions you can have per month.
High-yield bank accounts
High-yield bank accounts are exactly what they sound like: checking or savings accounts offered at your bank or credit union that have higher interest rates than you’d get from a standard account or a money market account.
Interest rates for these accounts are much higher, around 0.5 percent, but they often have more restrictions, such as higher minimum balance requirements, that may put them out of reach for some people.
Certificates of deposit (CDs)
A certificate of deposit is a type of account that banks offer. You put your money into the CD and after a certain period of time—usually one, three or five years—you can take the money out with interest. Interest rates fluctuate with the market and institution and depend on how long the CD term is.
In general, the longer the CD term, the higher the interest rate. One issue with CDs is that there can be penalties for early withdrawals. If you plan on using a CD for your emergency fund, make sure to know what the penalties are and factor those into your overall plan.
Other options for your emergency fund
While the above options are the best for keeping your emergency fund safe while easily accessible, they aren’t the only options. Stocks and bonds can help you grow your emergency fund, but they come with substantial risks.
If the market goes down, it takes your emergency fund with it, which means you may not have the funds when an expense comes up. This is also true for other popular types of accounts such as Roth IRAs.
However, the bottom line is that saving any amount of money in any way is better than nothing, so if you prefer to put your emergency funds in stocks and understand and are willing to accept the risks, you can do what works best for your family.
And the opposite is true as well—if all you do is put your money in a traditional low-yield savings account at your bank, that’s still a positive step for your finances.
Tips for building an emergency fund
Now that you know where to keep your emergency fund, it’s time to start building one. And this isn’t as difficult as it may seem. Everyone’s financial situation is different, but you can try some of these tips to start stashing some cash away:
- Create a budget. A budget doesn’t mean eating rice and beans forever. But it does mean knowing how much you’re spending and on what.
- Pay yourself first. It’s old advice, but it’s one of the most touted financial tips for a reason. Before you spend money on extras or splurges, make sure to put some money back to savings. Ten percent of your take-home pay is a good place to start if you have the wiggle room.
- Clearly define what you’re going to consider an emergency. Once you start to get a fair amount in your emergency fund, it can be tempting to treat a night you don’t want to cook or a great sale at your favorite store as an emergency—but it shouldn’t be. Make a list of things that are real emergencies and worth dipping into your funds from the beginning.
If you make a commitment to your emergency fund and keep it, you’ll be happy you did when something comes up and you need those funds. Having the money in the bank can also give you some extra peace of mind and a sense of security that’s invaluable.
