*Estimated Reading Time: 4 Minutes
Layoffs, medical emergencies, unexpected home or car repairs — life has a way of throwing expensive surprises at us. You never know what’s around the corner, so it makes sense to have an emergency fund. Most people know that they should have “three to six months saved” in case of an emergency. But the particulars beyond that confuse a lot of people. Well, know that you’re not alone. Today, I tackle seven common questions about this essential part of your financial plan.
1) Three to six months of income or expenses? Start by saving to cover expenses, rather than income. Ideally, you’re earning more than you spend. And even if not, you still need to focus on three- to –six months of your essential living expenses, not your income. Add up necessities like your mortgage, debt and insurance payments. You can leave out things like cable, the majority of your eating out and your entertainment expenses. If worse comes to worse, you can cut back or completely eliminate those expenses. Once you get the necessary amount saved up, you can then think about covering all your expenses for three to six months
2) Should I have three, four, five or six months? The common thought is three to six month of expenses. Yet some people, like Suze Orman, recommend eight to 12 months. The amount that you need depends on your specific situation and your tolerance for risk. You also need to consider your ability to bounce back if something happens. I often hear that having money in the bank makes people feel safe. For others having money not working for them seems wasteful. So pay attention to how you feel about your emergency fund, and use that feeling to guide your savings strategy. Also look at your overall financial situation. Do you support a lot of people? Do you have a spouse that can pick up the slack if need be? Do you have other financial tools (disability and life insurance, marketable job skills, low expenses, etc.) that can help in an emergency? I often say your financial life is like a set of dominos, so make sure you know how each piece affects another.
3) What if I can’t save that much? Having a goal like three, six, eight or 12 months of expenses intimidates a lot of people. And you’re likely not going to be able to save up the entire emergency fund immediately. But as the saying goes, “a long journey starts with a single step.” So start slowly. Focus on first on how much you currently have to save each month and start with that. As you begin to see progress, you’ll likely search for ways to save more to increase your momentum (cut some expenses, use your work bonus or raise, etc). Inertia will eventually take over, and you’ll get to your goal before you know it.
4) Where should I keep the money? You probably won’t — and shouldn’t — earn much of a return on your emergency fund. Savings accounts, short-term CDs and money market funds all yield less than 1%, and of course, you could earn more in a riskier investment. But that’s the problem. You need your emergency fund to be safe and readily accessible when you need it. Your best vehicle for that will be an online money market account. Check out Bankrate.com for online accounts that pay the highest interest. I also like analysis from sites like NerdWallet, which provide reviews based on different goals.
5) Does the bank matter? Interest rates change all of the time. And while your account may earn the highest yield one day, it could be middle of the pack or the lowest the next. (This happened to Ben and me with our individual Emigrant accounts.) Look for online banks that offer other services that interest you. For example, you may want great customer service, a local credit union, a user-friendly mobile app or maybe just the ability to talk to someone 24 hours a day if need be. A bank with an all-around great review may be worth a .25 reduction in an interest rate.
6) I saw online that I can use my Roth IRA. Is that true? It is! If you’re having trouble saving for emergencies and investing, you may be able to do both at the same time. With a Roth IRA, you can take out any money that you contribute to your account out at any time. (You just have to make sure to keep earnings in there.) You should still keep the money in cash-equivalent investment. However, if you are one of those people that really wants to invest part of your money, you could keep three months in cash and the other portion in short-term bond funds or CDs, if your provider offers it. You still won’t make a ton of interest, but at least the money will stay safe, which may not happen if you invest aggressively in an equity fund.
7) What constitutes an emergency? This is a really great, often overlooked question. The answer is different for everyone. Your emergency fund should only be used as a last resort in a true emergency. You want to use it for really serious situations like a job loss, an unexpected medical procedure or necessary repairs. To help with your in-the-moment decision making, you should define other emergencies for yourself beforehand and create policies around when you will and won’t use the money. Having a clear rule in your mind, will help make the decision easier when you’re tempted to use it for a non-emergency. Additionally, keeping this money separate from your regular checking account will also help guard against spending it on everyday living expenses.
One last tip that I don’t often get asked about that I like to point out is to keep cash in your house. At some point, you may find yourself in an extreme emergency – something as big as a natural disaster or as small as losing your wallet — when you won’t have access to electricity, internet or an ATM. Having cash in your house can help provide for your immediate need for food, shelter, or supplies. (It’s also helpful to have three days of supplies ready as well.) Just make sure to keep it in a safe place (where you’ll remember where it is) and have lower denominations that can easily be exchanged.
An emergency fund is an essential element of a strong financial plan. I hope these tips will provide you with practical guidance about implementing your rainy day fund into your overall financial picture.
About the Author
JD/CFP® helping LGBTQ couples thrive today and plan for tomorrow
Do you know XYPN advisors provide virtual services? They can work with clients in any state! Check out Brian's Profile