Where Should I Put My Emergency Fund? (Besides the Mattress)
Are you trying to decide if you need an emergency fund? Do you already know that you need one and are just looking for a way to start saving? Perhaps you want an emergency fund with a little extra yield. If any of these scenarios sound like you, keep reading because there's little bit of something here for everyone.
If You Don't Have an Emergency Fund
Unfortunately, many people may find themselves unprepared for even a modest expense when it arises. If you're a glass-half-full kind of person, it's important to realize that luck and chance happen to us all. Having to buy a new tire for the car, fixing the home air conditioner or covering your annual deductible can be a nuisance, let's be honest. In this day and age, though, that isn't the worst thing that could happen. Many people in the past 15 years have suffered through layoffs, restructuring and downsizing. Some of you may have been in poor health or had to take time off from work to help a sick family member.
With that in mind, how much should you really have saved if you want to cover something a little more dire than the washing machine going out on? First, let's look at the general guidelines provided by most financial advisers and then compare those guidelines to real life by looking at some numbers provided by the federal Bureau of Labor and Statistics.
Years ago, when I was studying to become a Certified Financial Planner, the general rule of thumb for emergency savings was multi-tiered and went something like this. If you are a dual-income household you would want to save enough to cover three months' worth of expenses, and if you are a single-income household you need to be able to cover six months' worth of expenses.
On the surface, this sort of makes sense and at the very least gives you a reasonable benchmark to shoot for. However, it's important to realize that these guidelines were developed within a framework that assumed that the client was financially responsible within all areas of their lives (i.e. they didn't carry massive amounts of credit card debt, had a reasonable car payment, and didn't buy more house than they could reasonably afford). On top of that, the information used to develop these guidelines was mostly based on employment data from the '80s and '90s. The problem with this is that since the end of the '90s, we've had a tech bubble, a housing bubble, a freeze in the credit markets and an energy bubble, all contributing to longer periods of unemployment for large swaths of the population.
How long are we talking here? Well, despite unemployment being in the low 5% range for the past four months, according to the Bureau of Labor and Statistics, the data also indicates that the average length of unemployment has been between 26 and 31 weeks (6–7.5 months) with the median between nine to 12 weeks (2.5–3 months). So what does this mean for you? It means that if you were to save three months of living expenses and lose your job, then you'd better hope that you fall into the median and not the average. While any amount of money set aside for emergencies is better than nothing, the most current data from the BLS indicates that your target for savings should be more in the 6-9 month timeframe. Now logic tells us that this is probably enough, but I'm a firm believer in Murphy's Law, which states that anything bad that can happen, will happen, and at the most inopportune time.
Because of this, I typically recommend that clients have a couple of extra months' worth of emergency savings just in case you have that car expense and medical expense at the same time that you are trying to look for the new job. If you don't already know what your monthly expenses look like, then use any of the budgeting tools your financial adviser provides, or some other type of budgeting tool – you can find many good free and paid budgeting tools online. Once you have this figured out, it's time to start saving.
Options for Emergency Savings
The best way to save is to set up an account that is separate from your primary spending account. Once this is done, you need to decide how you'd like to go about saving the money. Do you prefer it to come directly out of your paycheck and go right into the emergency fund account, similar to your retirement contributions, or would you rather have a little more discretion on the dollar amounts (i.e. the amount could change from month to month)?
If you prefer the former, then setting up automatic contributions from your paycheck should be as easy as logging into your company's HR web portal or reaching out to the company payroll group and providing them with the appropriate account number and dollar amount you'd like to systematically transfer. Typically, you'll be good to go within one to two payroll cycles.
If you prefer a little more discretionary control over how much you move in any given month, you could typically setup an ACH connection that allows you to move money whenever and however you choose. Quite honestly, this is the easy part. The tough part is choosing how you would like to invest the money in your emergency fund. Please realize that I use the term "invest" rather loosely, since emergency fund money really should remain in cash or some type of cash alternative. The most appropriate options for your emergency fund money are checking accounts, savings accounts, money markets or certificates of deposit.
How Do You Choose?
Let's take a closer look at your options to help you determine the best method for you. Checking accounts typically pay the lowest interest rate on your money, which at this time is right around 0.05%. Not exactly something to write home about. Savings accounts and Money Markets can pay quite a bit more, especially if you shop around a bit, even getting up to 1% APY. The big catch with savings accounts and money markets is that, due to FSB Regulation D, you are usually limited to 2-6 withdrawals in any given month. If you exceed these limits, you can be charged additional fees that can quickly eat into your higher yield.
For those of you who are looking for a little more yield and have more than $20K already saved, you may consider CD laddering. It takes a while to get the strategy fully implemented, but can pay off over time (if all of this were couch potato-easy then everyone would be Warren Buffett).
Basically, you divide your total emergency fund by five. Let's say, for easy math, that you are starting with $25K. This means that one-fifth is equal to $5K. Take that $5K and buy a 1-year CD, which you can get with an APY at or above 1.25% right now. Leave the remaining in cash and set a calendar alert on your phone. In three months, you will once again go out and buy a 1-year CD at the prevailing rate — hopefully it's a little higher than your last CD — leaving the remaining money in cash. If you did your math right, at the end of 12 months you will now have four active CDs totaling four-fifths of your emergency fund with the remaining fifth sitting in cash. By laddering the CDs with shorter duration (one year) you will constantly have money coming available to you every three months, and you will also be able to take advantage of any increase in interest rates. This can be the best of both worlds.
Beware of Over-Reaching for Yield
I will never be able to stress this enough – for an emergency fund, consider keeping your cash as cash and, at the least, a CD. I highly recommend against seeking yield on emergency fund dollars by investing in things like ultra-short bond funds, high-yield money market funds, municipal resets or auction rate preferreds. Remember that it wasn't that long ago that many retail investors discovered the reach for yield could have dire consequences. In 2007 and 2008, folks were trying to eke out a few extra dollars by investing in the aforementioned investments only to be met with heartache. People that really needed their cash found that the credit markets froze up, the auctions failed, ultra-short duration bond funds like the Reserve High Yield broke the buck, and even money market mutual funds were unable to pay out their investors. All of these instances were resolved over time, but if you were some of the unlucky few who actually needed cash in the midst of the Great Recession, then it's likely you were out of luck. With these things in mind, consider letting your cash be cash, or at least a short-duration FDIC-insured CD.
Think about how an emergency fund could function in your life. Relying on credit cards in a true emergency may be a short-term fix, but cannot sustain you over a longer period of time without potential financial damage (you can see how your debts are affecting your credit by getting your credit scores — many sources offer them for free, including Credit.com). Optimism can be a very good thing, but so can having a safety net for more challenging times.
Note: It's important to remember that interest rates, fees and terms for credit cards, loans and other financial products frequently change. As a result, rates, fees and terms for credit cards, loans and other financial products cited in these articles may have changed since the date of publication. Please be sure to verify current rates, fees and terms with credit card issuers, banks or other financial institutions directly.
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