If there’s one thing I know, it’s that emergencies happen. Yet, it’s difficult to build wealth when you’re one setback away from financial disaster. That’s why a cash cushion, like an emergency fund, is critical. Your financial future depends on it. And yet, 57 percent of all single female households in the United States do not have sufficient savings to live for three months at the poverty level if they lost their source of income (women need an emergency fund more than anything!).
I am a financial planner, and I can tell you firsthand that many of my clients struggle with saving an emergency fund. While some of my clients are focused on paying off student loans, others are more excited to save for other goals.
Here’s what I think: emergency funds should be boring – but you need one anyways!
The Size of Your Emergency Fund
You need an emergency fund because it’s the first step toward building wealth and achieving financial security.
I recommend that you save up to three to six months of take-home pay in your emergency fund.
There’s no need to put off saving to pursue other financial goals like paying off credit card debt, tackling student loans, and saving for retirement. Just start with $25 a month if you need to. Once you fund your emergency fund, you’ll be able to move on to your other goals.
The Importance of Your Emergency Fund
Money set aside in an emergency fund should be treated much differently than other pots of money. Your emergency fund is your safety net. It’s the money that keeps you safe when something goes wrong. So, guard it and make sure it’s easily accessible. Practically, this means that it shouldn’t be in the market or hard to get to. And wherever you keep it, make sure it’s in place that is FDIC insured (so that your savings are safe no matter what happens to the bank you’re in). You can find this out easily by asking your bank, credit union, etc.
It’s also a good idea to put your emergency fund in a different account than the one you pay your bills out of. You don’t want to accidentally spend the money you are saving for your financial future, or worse – be tempted to spend the money on something you want instead of keeping it for emergencies. A trip with friends is not an emergency. When it comes to saving for an emergency fund, the idea “out of sight, out of mind” works. So, put your emergency fund money in a separate account and don’t touch it. This way, when you really need it, it’s there.
Where to Put Your Emergency Fund
Now that you know how critical it is to have protect your emergency fund, you need to choose where you actually keep this money. The purpose of your emergency fund is to have cash set aside to protect you when an emergency happens. For this reason, your emergency fund should never be exposed to the market (e.g.: in a mutual fund or stock). Imagine if you lost your job in 2008, during the recession, and you had your emergency fund in the stock market. You would be in serious trouble because your money would be worth a lot less than you put into the market, and you wouldn’t have time to wait for it to recover. The purpose of an emergency fund is not to earn money and invest – the purpose of an emergency fund is for it to be there when you really need it.
With this in mind, there are three great places to store your emergency fund: a savings account, money market fund, or a CD.
A savings account is a great place to stash your emergency fund. Savings accounts earn a bit more interest than what you’ll find in a checking account, and they’re FDIC insured for up to $250,000 per depositor, per bank.
The account is still separate from your checking account, but it’s easy to transfer money back and forth. Many banks will allow you to set up an automatic transfer from your checking account to your savings account to make saving money automatic. Online banks or local credit unions usually have the best rates for savings accounts.
A money market acts similarly to a savings and a checking account. A money market is FDIC insured as long as it’s deposited at a bank, and you can write a limited number of checks from the account per month.
While most money markets have a larger minimum deposit requirement, the accounts usually offer a higher interest rate than a savings account. With money market accounts, the bank invests in safe investments like Certificates of Deposits and short-term bonds, and then passes on a higher interest rate to you. Once you’ve made the minimum, these accounts are a great place to keep your savings.
Certificates of Deposit
Certificates of Deposit (CDs) are promissory notes issued by a bank. You promise to invest the money with the bank for a certain period of time, and the bank promises a fixed interest rate in return. If you withdraw money from the CD before the CD term, you’ll often be subject to an early withdrawal penalty.
Some CDs do offer attractive rates, but since the money is less liquid, you don’t want to lock up all your money. It can make sense to keep 3 months of take home pay in a money market, and then keep the second three months in a CD. You’ll also want to make sure that the CD is easy to break if needed. Some CDs offer a lower penalty for withdrawing early than others, and some allow a partial withdrawal of funds. You can also split the money into multiple CDs to avoid breaking the CD for a small emergency. Read the fine print to know exactly what you’re getting into.
I’ve found that my clients are more excited about paying down debt or investing to build wealth than they are to save up for an emergency fund. While it may not be the most glamorous part of personal finance, it is necessary for your financial success. Your emergency fund will keep you financial safe when you need it, and for that reason, it’s important that you keep your funds easily accessible (liquid).
If you’re not sure where to get started, the best thing you can do is to smart small. Whatever you can afford this month, do it. Put something – anything – into an account and start saving little by little. Get on a budget if you need to. Over time, you’ll see your account increase and you may even be inspired to save at a faster rate. When an emergency happens, you’ll be ready.
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This is a guest post, written by Katie Brewer, CFP®. Katie is a financial coach and the President of Your Richest Life, a fee-only financial planning firm.You can find her on Twitter at @KatieYRL or email her at email@example.com.