Hi there.
An emergency fund is money that you set aside so that you can handle unexpected expenses, and they stay that way.
When it rains, and I assure you that it will rain, you need to have a cushion to soften the blow and handle the emergency. Blown tires; broken water heater; unexpected loss of a job. These things happen all the time.
The problem isn’t necessarily that you can’t pay for an unexpected expense. It’s the damage that happens when you have to pay for the expense out of your investment accounts (which happen to be down), or with high interest debt that you have to take on. Liquidating your retirement because you got let go unexpectedly is a triple whammy – you have the loss of income, stop contributing to your retirement accounts, and draw them down (sometimes with a tax penalty).
How do you protect yourself from things like this? Be sure to have a cushion. Something really safe, soft and nice makes an excellent pillow and will help you sleep at night.
Be aware of expenses that you know are coming, and treat them differently than your emergency fund. The big purchases that will happen in the next three years – weddings; education costs; a new home purchase. These are outside the unplanned emergencies, but there needs to be cash reserves for them.
The collective wisdom is your emergency fund should be 3-6 months of expenses for families with multiple incomes and 6-12 months with families with a single income. You can get quite a bit more granular than that. Do you have a really high-income job? Those take longer to replace. Do you have a rental property or a business? You should build that in as well. Are there known expenses like a large tax bill coming due next year? These are all reasons to carry more than the “standard.”
Once you know your pillow size, the question is: “Where do you keep it?” Personally, I’m a big fan of brokerage money market funds and bank savings accounts. They’re boring because they’re simple. Brokerage money markets pay a floating rate that’s tied to short term treasury yields. In most cases, you can get the funds from your brokerage account within a few business days. Banks typically pay less, but you can get your funds on the same business day.
Both are more efficient than a checking account paying nothing, but you have to remember that’s not really the point of the emergency fund. It’s not supposed to be efficient. It’s supposed to be boring, and just be there when you need it. Your financial success won’t be made or broken by the interest you make from your emergency fund.
Even so, what I generally walk people through is keeping your emergency fund (at least 3-6 months of your expenses) in a high-yield bank savings account that pays anything above 0%. Anything more – the bigger pillow, or planned major purchases in the next three years – goes in a bank CD or brokerage money market account.
Online banks typically pay more than brick and mortar, but they can be more difficult to deal with. Many banks offer a bonus period where the funds earn more, and then the rate slowly decreases. Banks don’t want to pay you anything if they can get away with it, so it won’t stay high, and they’re typically not under any requirements to offer higher rates. Having a good relationship with your banker can go a long way.
Your brokerage money markets (the cash position in an investment account) will pay a rate that is comparable with what short term treasuries are paying (less the expenses of the fund). These rates float and change, and are based on the supply and demand of the short term treasuries that are issued. So the rate won’t suddenly drop to 0% without notice.
For those of you who have a bank savings account, when was the last time you checked your statement to see what you’re making? It’s probably less than you think.
Until next time, God Bless.
Ian
