It is widely regarded by personal finance experts as essential to keep a minimum of three to six months’ worth of expenses in savings, your “emergency fund.”
However, if you’re mired in debt, it’s not in your best interest to accelerate your burial by paying just the minimums in order to set aside savings. Then there’s the questions of when to save, how much exactly you should save, and where to park your amassed savings. We’ll explore those factors so you can reach a better-informed decision.
When to Start Saving for Your Emergency Fund
If you’re at all familiar with the world of personal finance, you’ve probably heard of Dave Ramsey. His famed “baby steps to financial freedom” feature building an emergency fund of $1,000 as step number one. Baby step number two is to pay off all debts except your mortgage, using the snowball method (which I advise against). Three is to build up an emergency reserve of three to six months of expenses. Only in baby step number four does he advocate starting to invest.
I essentially agree with Ramsey’s advice that you should pay off your credit card, student loan, and any other relatively high-interest debt before moving on to build a minimum three-month reserve of living expenses and then investing; for one, it doesn’t make sense to be building up a large reserve that could be costing you significant amounts in interest (which can then capitalize, or be added to the principal, becoming the basis from which future [compound] interest is calculated). Secondly, knocking out your debts means that in the case of an emergency such as losing your job, you won’t be encumbered with the obligation of meeting their minimum payment requirements.
However, if you’re postponing the establishment of a complete emergency fund (that is, covering a minimum of three months’ worth of expenses rather than just your barebones $1,000) due to your debts, that path is advisable only assuming you’re putting the extra money that you would be putting toward your emergency fund instead toward paying off your debts. You should have a laser focus pointed at getting rid of them as quickly as possible.
How Much to Save for Your Emergency Fund
As discussed in the previous section, if have nonmortgage debts, you should have an emergency fund, but a smaller one. If you don’t have money set aside, work toward scraping together $1,000 as your bare minimum to fall back on.
Once you aren’t being dragged down by excessive debt, you can shift your attention to building up a more substantial fund of between three to six months’ expenses, the range traditionally advocated by financial planners.
The right amount depends on your individual circumstances and comfort level:
Do you have a stable job? Do you get along well with your supervisor(s)? Keep in mind that if you’re fired it may be difficult to prove that it was not due to fault of your own, which is a criterion of receiving unemployment checks. If you sense that your supervisor has an erratic personality or that they aren’t always kind toward you, that’s a strong indication you should save more.
Are you self-employed with highly volatile income?
Do you have dependents? If so, not only could it be devastating if you suddenly cannot continue providing the usual amount for their needs, but you are also responsible for covering any emergencies that may arise in their day-to-day life.
Is your household dual or single income? Certified Financial Planner guidelines suggest at least a three-month emergency fund for the former and a six-month emergency fund for the latter.
Are you fit and healthy, or are you more prone to health issues?
Do you feel comfortable in your current housing arrangement, including getting along well with whomever you’re living with and your landlord(s)?
Do you live in a crime-ridden locale with a higher risk of break-ins, car theft, etc.?
Do you have people in your life who would gladly support you should you find yourself in a bind?
Could you withstand a sudden breakdown of your laptop, car, or any other equipment you may rely on for work, or would you need to repair and/or fix it immediately?
Have you set a high risk-retention limit for yourself, opting for high-deductible health insurance and passing up opportunities for buying insurance on things with a lower cost and risk? You’ll likely reap savings from such strategy, but it also means you should have more set aside to cover any accidents that may occur.
Another consideration is that with a larger reserve of savings, you can afford to take more risk with it such as by investing it in a short-term bond fund.
Where to Keep Your Emergency Fund
Once you’re ready to put together your barebones $1,000 emergency fund, or if you’ve gotten most of your debt paid off and are ready to shift your attention to building a minimum three-month emergency fund, it’s time to figure out a smart place to park it.
These should be key considerations in your search for the perfect spot:
- Generally speaking, it should be liquid—in other words, you should be able to withdraw it as cash as needed. However, having credit cards changes this picture (see below).
- There should be low risk and volatility; you don’t want to put it where it could be reduced to nothing overnight.
- The tax implications.
- The effects of inflation.
- Fees that could reduce your returns—seek out the absolute minimums in fees.
Credit cards allow flexibility with an emergency fund. If you have several credit cards with a lot of credit available (at least several thousand dollars), it isn’t as important to have a highly liquid emergency fund. If you always pay your credit cards’ statement balances off by their due dates (taking advantage of the ‘credit card grace period’), you don’t have to pay a dime of interest; when used properly, credit cards function as interest-free loans. Still, you should be keeping your total credit usage across all credit card accounts below 30% at any given time. For these reasons, it’s wise to be a responsible credit user and to have several credit cards for a high total credit availability. See Credit Scores 101 for more information on the topic.
I believe you should put your emergency fund where it will generate additional income after the effects of inflation and taxation.
You generally won’t find savings accounts, money market accounts, certificates of deposit, or money market funds with a return above around 1.5% (which would be considered very high). Among those options, money market mutual funds tend to offer the best rates, and they are unique in that they come in tax-free versions.
The typical rates of those options are too low—your emergency fund will be slowly eaten away by inflation. There is also an opportunity cost in keeping your fund in low-yielding accounts; the psychological security of having money in a “safe” (nonvolatile) account comes at the expense of investing with significantly higher expected returns.
Fortunately, however, there are many credit unions offering checking and savings accounts with rates as high as 7.5%. They tend to come with some requirements, such as completing a certain number of monthly transactions and setting up direct deposit, which are off-putting to some. But I find most of them to be manageable and worth the extra effort, and I advise you to keep as much of your emergency fund in those types of accounts as you can manage. If you go this route, try to find an account offering an absolute minimum of 3% APY.
If you have a large safety net of credit cards (and, as mentioned above, you have a total credit availability of at least several thousand dollars and always pay your credit cards off on time), you can afford to invest your emergency fund, or at least a portion of it; investing in bond and perhaps even stock index funds and relying on credit cards as a crutch would be your second best option after putting your savings reserve in a minimum 3% APY bank or credit union account. A 2013 study examining the implications of holding an emergency fund in cash (checking accounts, savings accounts, money market deposit accounts, CDs, etc.) as opposed to stock and bond investments came out in support of that strategy, concluding that “The traditional recommendation of a cash-only reserve emergency fund strategy is likely to reduce wealth over a lifetime. Furthermore, this strategy is less likely to meet emergency needs.”
Any earned interest in checking, savings, certificate of deposit, and money market deposit accounts from credit unions and banks is fully taxable as ordinary income (which varies based on your tax bracket). For instance, if you make $40,000 per year (before taxes are taken out; your gross income), you’re in the 15% tax bracket; a 5% APY means earnings of only 3.75% after tax in that scenario.
On the other hand, you may have lower or no tax with investments in money market mutual funds, stocks, bonds, etc.
Capital gains, profits from the selling of investments, are taxed at either the short- or long-term capital gains tax rate, and are calculated by subtracting the “cost basis,” the amount an investment was purchased for, from the amount it was sold for. The short-term capital gains tax rate, which applies to securities held onto for one year or less, is simply the normal income tax rate. For securities held onto for 366 days or more, the long-term capital gains tax rate applies and is significantly lower, particularly for those in the upper and lower tax brackets.
If you invest from within a tax-sheltered retirement account such as a 401(k) or traditional IRA, you won’t have to pay taxes on growth until withdrawal. However, if you needed the money in an emergency, you’d have to pay penalties for early withdrawal, making a retirement account a very poor place for an emergency fund. For instance, if you withdraw from a 401(k) or IRA (including the Roth and traditional types) under the age of 59 and one-half (don’t ask me why they couldn’t make it a whole number) you’ll have to pay a 10% penalty in addition to taxes. Ouch.
Note that seven states don’t charge state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
As for inflation, the Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.9%. However, it was at about 3% throughout the 1900s, and Morningstar reports that it averaged 3.4% between 1914 and 2012.
So if you assume a pessimistic, err, conservative 3% inflation rate, the return is down from 5% to 0.75% APY (in this example, counting the 1.25% loss to taxation I’d incur given my 15% tax bracket).
APR vs APY
When evaluating your savings location options, you’ll probably encounter APY most frequently. The difference between annual percentage rate (APR) and annual percentage yield (APY) is based on whether or not compounding is accounted for.
Compounding is what occurs when earned interest is added to the principal (the amount originally invested along with any interest that may have compounded already), which future interest is calculated from.
APR is the interest rate you’d be charged for borrowing or that you would earn from an investment in one year that does not take into account the effects of compounding.
APY is the actual interest returned in one year after taking into account compounding that occurs intra-year, or over the course of the year. It varies based on how often compounding occurs—it could be daily, monthly, quarterly (every three months), semiannually (every six months), or annually.
Credit Unions vs Banks
Credit unions and banks are both financial institutions that offer many of the same services: checking and savings accounts, mortgages, and auto loans, to name a few. The key difference between the two is that credit unions are nonprofit cooperatives while banks are for-profit companies.
They both invest deposited money into income-generating investments such as loans. However, while banks use the net profits to pay to their shareholders in the form of dividends and share buybacks, credit unions use the profits to offer better interest rates to their members.
Bank account deposits are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor and per bank, while deposits with federal credit unions are backed by the National Credit Union Share Insurance Fund (NCUSIF) also for up to $250,000.
State-chartered credit unions may have their own state or private insurance if they aren’t backed by NCUSIF.
You can expect lower fees from credit unions (as well as online banks, since they don’t have expenses associated with providing services at a branch).
For more details see Credit Unions vs Banks.
Savings Accounts vs Checking Accounts
Note that credit unions’ savings accounts are actually called “regular shares,” and their checking accounts are called “share-draft accounts,” but they are nonetheless commonly referred to as savings and checking accounts.
Most checking accounts don’t offer interest, while savings accounts offer some. The average APY of interest-bearing checking accounts is 0.04%, while that of savings accounts is 0.06%.
Because savings accounts have more barriers to accessing the money, there are lower fees, if any, for having them. Some financial institutions charge a monthly fee that may be waived if you meet a minimum balance requirement (avoid these; there are lots of banks that don’t charge fees).
The Federal Reserve imposes a monthly limit of six “convenient transfers” out of savings under Regulation D, which include debit swipe, online transfer, and checks. Withdrawal via ATM or teller is not considered a convenient transfer.
Money Market Deposit Accounts
A “money market deposit account” (MMDA), or simply “money market account” (MMA), is like a basic savings account but typically with a higher minimum deposit and balance, which comes as a trade-off for a higher interest rate. Like savings accounts, it too has a limit of six convenient transfers per month.
Unlike money market funds, they have FDIC (at banks) or NCUA (at credit unions) backing up to $250,000 per depositor.
The average return of a money market account is 0.12% APY.
Certificates of Deposit (Offered by Banks) or Share Certificates (Offered by Credit Unions)
A bank certificate of deposit account, or “share certificate” from a credit union, which is likely to offer more interest than a money market account but stipulates that you lock up your money for a fixed amount of time (from a few months to a few years). The longer time frame you agree to, the higher the interest rate you can expect. If you withdraw money early, you’ll face a penalty of forfeiture of a proportional number of months’ interest, except in the case of penalty-free CDs. No-penalty CDs are rarer and likely offer lower rates than their traditional counterparts. Ally, however, offers a no-penalty CD with a relatively attractive rate of 0.90% APY for balances below $5,000.
CDs are also federally insured by FDIC or NCUA up to $250,000.
Unlike bonds, their underlying principal doesn’t fluctuate.
Per FDIC, some average returns (using APY, which takes compounding into account) on CDs for deposits below $100,000 are:
- 1 month: 0.06%
- 6 month: 0.14%
- 12 month: 0.26%
- 24 month: 0.42%
Money Market Mutual Fund
While not federally insured, money market mutual funds invest in very safe (low-risk) lending investments such as short-term bank certificates of deposit and bonds (often with maturity dates of three months or less), and they keep on hand $1 for each $1 you have invested with them (banks, by contrast, only are required to keep up to a dime).
Unlike the majority of mutual funds, the principal value normally doesn’t fluctuate, since money market mutual funds are designed such that their net asset value (NAV, which is the per-share price) is fixed at $1.
There may be high minimums for check writing.
Further, some money market mutual funds have both state- and federal-tax-free versions, which could benefit those in high tax brackets.
Short-term bonds offer a higher expected average yield than money market mutual funds, making them the highest-yielding category among the emergency fund settings discussed in this article.
Like money market mutual funds, they are not FDIC insured; however, they too are considered to be a low-risk investment.
Beware that it’s riskier investing in short-term bond funds than short-term bonds alone, as bond funds don’t have a set maturity date. On the other hand, you can be certain you’ll receive your principal back at the set maturity date of an individual bond so long as the issuer doesn’t go bankrupt (which is very unlikely with well-known corporations and essentially impossible in the case of government bonds.