Almost every personal finance expert agrees that the first step to financial freedom is starting an emergency fund. But how big should your emergency find be? And where should you keep your emergency fund?
Most financial experts recommend an emergency fund equal to the size of three to six months of your salary. That’s not a bad rule of thumb, but a better way to base the size of your emergency fund is on the amount you normally spend, not your income.
An emergency fund should contain enough money to hold you over financially if you should lose your job or otherwise become unable to earn an income. Emergency funds are also useful when you have unexpected expenses such as large medical expenses, unexpected travel, or major car or home repairs that cost more than you budgeted for. Let’s take a look at how you can determine how much money you should set aside in your emergency fund.
Why Do You Need an Emergency Fund?
An emergency fund is one of the most important financial steps after becoming current on your living expenses and graduating from living paycheck to paycheck. With a little planning and luck, it can help you manage unexpected expenses and avoid debt.
If your goal is building wealth while avoiding most of life’s financial pitfalls, an emergency fund can help on both fronts.
Not only can an emergency fund serve as another form of savings you can use later in life, but setting money aside for emergencies is crucial if you face a surprise bill you can’t afford to pay, you lose your job, or you experience a loss in income.
How Much Should Be in Your Emergency Fund?
Each expert has an opinion, and the answers vary.
Generally, experts recommend you have at least 3-6 months of living expenses. It’s probably feasible to start with $1,000 and work your way up from there. However, this varies depending on your circumstances.
For example, many military members have very stable job situations. That isn’t always the case for some members forced out of the service through a force reduction or for many of the millions of Veterans hit with layoffs and reductions in the civilian workforce.
Most experts agree that you should base your emergency fund on your expenses, not your income.
So, if you measure your emergency fund in months, it makes more sense to measure expenses in months, not income.
As you cut other expenses from your budget and look for more sources of income, you can begin increasing the amount of money you put into your rainy day fund. But first, you must be in the habit of “paying yourself first.” If you have a CD ladder or other type of investment that is fairly liquid and could be removed if necessary, you may be able to keep a smaller emergency fund as well.
Don’t consider your 401(k) or IRA-type accounts as money you can access because they are not easily turned into cash and are much too expensive to withdraw before retirement age.
At a bare minimum, an emergency fund equal to your minimum monthly expenses for three months should hold you over long enough to find work (even if it pays less than your current job) and help you transition should you have to reduce your expenses to match your new income.
Where Should You Keep Your Emergency Fund?
While having an emergency fund is important, deciding where to store it can be much less straightforward. If you’re hoping for a more secure spot for your emergency fund than under your mattress, here are your options and why you might want to choose each one:
1. Brick-and-Mortar Bank Location
For those just starting an emergency fund, opening another account with your current brick-and-mortar bank can be a great option. You can link your current checking or savings account with your emergency fund, making it very easy to set up automatic transfers into the account. Using your current bank also means you can make deposits in person or at an ATM.
The downside to this, however, is how easy it is to access your money from this account. Just as you can easily deposit money into your emergency fund from the ATM or with a teller, you can also withdraw money just as easily. In addition, you will earn next to no interest with this option.
If you have the discipline to leave your money alone, this is a good place to build your emergency fund from the ground up safely.
2. Online Savings Account or Money Market Deposit Account
Though these accounts are less convenient than a local brick-and-mortar bank, they offer much better interest rates. You can deposit money in these savings accounts through linked traditional bank accounts and by mailing in deposits. Your bank might also have the option of mobile deposit, which you can submit online.
One major downside is the lack of convenient access to your money. Funds generally take two to three business days to fully transfer from an online savings account.
3. Certificate of Deposits
A certificate of deposit (CD) is an insured and interest-bearing account with a fixed term during which it is not in your best interest to withdraw your money. Since you (theoretically) keep your money in the CD for the entire term, the CD interest rates banks offer will be better than from any savings account.
However, if you withdraw your funds early, you will have to forfeit some interest—generally about two to six months’ worth.
Stowing your entire emergency fund in a CD is not always a great idea since it is not particularly liquid. However, if you also have money set aside in a more accessible account, putting away a portion of your emergency fund into a CD helps ensure you have funds set aside for “life happens” moments while still earning some interest on that money. You can also mitigate CD penalties by using no-penalty CDs or a CD ladder, a series of CDs with different maturity dates, giving you more frequent access to your funds without having to pay penalties.
4. I-Bonds or Other Government Bonds
These U.S. Savings Bonds are inflation-indexed, meaning you start with a particular rate of return when you buy them, and those rates are readjusted every six months to reflect the inflation rate. In short, these are a good place to earn real interest on your money—and you defer paying taxes on your earnings until you cash out your bonds. However, you cannot withdraw your funds from I-Bonds for a year after you have purchased them.
Again, while I-Bonds can do more with your money, you will be in severe trouble if you put all your emergency funds into them. In addition, there is a $10,000 purchase limit per person per year. Wait to buy an I-Bond until you have established a good emergency fund and can afford to put a portion out of reach.
5. High-Yield Savings Account
A high-yield savings account can be a smart place to keep your emergency fund, provided you conduct due diligence to find an account with a decent APY. These accounts are easy to research and open on your own. Plus, many high-yield savings accounts offer online account management services so you can keep track of your balance, make deposits and withdrawals, and oversee your account details from the comfort of your home.
Before opening a high-yield savings account, ensure you know the deposit requirements or rules that dictate how much interest you’ll earn. Here are some recommendations for the best high-yield savings accounts to get you started.
The Bottom Line
If you’re building up an emergency savings fund, you’re on your way to setting up your finances well. Remember, the amount you set aside should be based on your monthly expenses, not your income, as this provides a more realistic safety net.
Where you store your emergency fund is just as crucial as how much you save. For beginners, a high-yield savings account or a money market account can offer a balance between earning interest and maintaining accessibility. If you’re disciplined and want to grow your savings further, consider diversifying into options like CD ladders or I-Bonds. These can provide higher returns but ensure you’ve already set aside a liquid portion of your fund for immediate emergencies.
Any of these accounts could work well for your needs, so compare them based on your risk tolerance, financial goals, and how quickly you might need access to your money. An emergency fund is crucial to your financial health, but the best place to keep it differs for everyone. Take the time to evaluate your options to ensure you’re prepared for life’s inevitable surprises.
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John Travis says
We have about 3 months of our necessary expenses in a money market account. It fluctuates somewhat because we don’t have a separate account for periodic expenses (vehicle maintenance, vacations, etc.). For us, this is still a very low percentage of our assets, so I don’t worry much about the low interest.
Daisy@Everything Finance says
My emergency fund is about 4-5 months worth of living expenses. Sometimes, I hate that it’s just sitting there in a low interest account, but I guess it’s important to have it available to use.
John says
I think 3 to 6 months is a good amount. if you don’t have a lot of risk in your life, three months is probably adequate. Otherwise, shoot for six months worth.