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 You Need an Emergency Fund – And How Much You Need
It should be pretty obvious why you need an emergency fund: emergencies are a fact of life. If your car broke down or you had to fly out of town for a funeral, how would you pay for that unexpected expense? An emergency fund takes some of the stress out of these stressful situations since you know where the money will be coming from.
Calculate Your Monthly Expenses
First, sit down and figure out how much you pay out in an average month. Only count expenses that are absolutely necessary, so for the purpose of figuring out how much money you need in your emergency fund, you can ignore almost anything in your budget that isn’t required. For example, you may be able to temporarily postpone or eliminate expenses such as a vacation fund, cable television bill, gym membership, dining out regularly, entertainment, clothing expenses, and some other items.
Make a list of your monthly bills for your home, including rent or mortgage and utilities. Include transportation expenses, insurance, debt payments, groceries, medical expenses, tuition, taxes child care, and other fixed expenses.
Once you have calculated your required monthly expenses, you need to decide how many months you want to have saved in your emergency fund to cover those expenses if you should lose your job.
Number of Months Your Emergency Fund Should Cover
While experts claim three to six months is necessary, each emergency is different. Many military members have very stable job situations, but that isn’t always the case for some members who are forced out of the service through a force reduction, or for many of the millions of veterans who are hit with layoffs and reductions in the civilian workforce. Because each situation is unique, it’s hard to say how long it might take you to find financial security, especially in a struggling economy.
Keep in mind, if you have a spouse with an income – you don’t need as much money in an emergency fund as someone who is single or the only source of income for the family. You and your spouse (unless you work in the same place!) are unlikely to both lose your jobs at the exact same time.
If you receive money from a trust fund, alimony, child support, self-employment income, or other sources of income in addition to your job, you can modify the amount of your emergency fund by that much money. So if you receive $200 a week in child support payments, you can reduce your monthly expenses by $200 per week (since you know you have that much coming in each week) and save less in your emergency fund.
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 you reach 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?
Unfortunately, even though the need for an emergency fund is obvious, where to stash it is definitely less so. 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:
With Your Current Bank
For those just starting an emergency fund, opening another account with your current brick-and-mortar bank can be a great option. You will be able to link your current checking or savings account with your emergency fund, which will make it very easy to set up automatic transfers into the account. Using your current bank also means that 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 deposit money into your emergency fund from the ATM and with a teller, you can also withdraw money just as easily. In addition, you will earn next to no interest with this option.
However, if you have the discipline to leave your money alone, this is a good place to safely build your emergency fund from the ground up.
Online Savings Accounts
Though these accounts are not as convenient as a local brick-and-mortar bank, they do offer much better interest rates. You can deposit money in these savings accounts through linked traditional bank accounts, as well as by mailing in deposits.
The lack of convenient access to your money can often be a boon. It generally takes about two to three business days for the money to fully transfer from an online savings account, which is plenty of time in the face of a true emergency (I often will pay via credit card, for example, and use the emergency fund money to pay off that bill), but is far too much time when spending temptations strike.
Certificate of Deposits
A certificate of deposit, or CD, is an insured and interest-bearing account that has a fixed term, during which time it is not in your best interest to withdraw your money. Since you (theoretically) keep your money in the CD for the entire term, banks will offer you better interest rates than you can receive from any savings account. However, if you withdraw your funds early, you will have to forfeit some amount of 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 is a good way to make sure you still 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 by using a CD ladder, which is a series of CDs with different maturity dates, giving you more frequent access to your funds without having to pay penalties.
I-Bonds or Other Government Bonds
These U.S. Savings bonds are inflation-indexed, which means you start with a particular rate of return when you buy them, and those rates are readjusted every six months to reflect the rate of inflation. 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 up a creek if you put all of 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 a good emergency fund established and can afford to put a portion of it out of reach.
The Bottom Line
Starting an emergency fund is the most important part of this process. Once you get in the habit of putting money aside, then you can decide where your money will work best for you.