The concept is simple — money is set aside to meet the needs of a sudden financial emergency. For most, an emergency fund differs from other more general savings in that it is for a specific purpose and it is kept in a very liquid state.
While an emergency fund can be for any financial emergency, most financial advisers recommend individuals think of it in terms of monthly expenses, in the event that someone loses their job.
How Much Should be Saved in an Emergency Fund?
For many years, financial experts told people to keep about six months’ worth of living expenses in an emergency fund. The recent downturn in the economy, however, has many of these experts refining this advice. Many pundits now say that the average household should keep at least eight months’ worth of living expenses in emergency funds.
An emergency fund can take the form of borrowing capacity or as tangible, liquid assets. Borrowing capacity may include an available credit card balance or an open line of credit on a home equity loan (establishing a home equity line of credit can take some time, so don’t count on your home equity as part of an emergency fund unless you have an established borrowing arrangement to tap into that equity).
Credit’s Role in the Emergency Fund
While credit is a viable source for an emergency fund and certainly has its place in the portfolio, relying on credit in a financial emergency is more risky than tangible assets. A borrowing arrangement can be cancelled or interest and other costs can increase. While borrowing capacity shouldn’t be ignored, these risks should be mitigated (borrowing generally serves to bridge the gap between the expenditure and access to longer-term assets). The best mitigation is to have a sufficient population of liquid assets available to supply the emergency fund.
Emergency money should be more than a stash of cash. While liquidity and security are of paramount importance, growth is critical as well. Without a return on these funds, inflation will slowly diminish the emergency funds’ real value.
Interest rates are at historic lows, but they are still above zero. Instead of stashing cash in a safety deposit box, consider this structured approach to invest your emergency fund.
Start by keeping one to two months’ worth of expenses in a checking account. Most checking accounts pay virtually no interest, so it doesn’t make sense to put a lot into this account. This fund can be used to pay immediate expenses as well as the immediate month’s living expenses in the event of a sudden job loss.
Savings and Money Market Accounts
Next, keep about four months’ worth of expenses in a savings or money market account. While emergency money in these accounts will earn very little interest, they will earn more than they would in a checking account. This money is intended to be readily accessible in a matter of days (or at most a week), without penalty. While these investments cannot be accessed on demand (as with emergency money in a checking account), they can be accessed extremely quickly with just a few days’ notice.
Certificates of Deposit
The remaining emergency fund investment can take the form of certificates of deposit (CDs), ranging — or “laddered” — from between 3 to 6 months. While money invested in a CD is much less liquid than either money market, savings or checking accounts, it normally earns a better rate of interest. As the CDs mature, they can be “rolled” into another CD if the money is not needed.
Other Emergency Fund Investments
Emergency funds in excess of the amounts discuss above should be stored in Treasury bills. These bonds will give an investor a higher return than any other cash investments, while still maintaining great liquidity and security.
Another alternative that many have available to them is their Roth IRA contribution balance, which can be withdrawn at any time, without a penalty or tax. Earnings on the Roth IRA balance may be subject to taxes and penalties, but the contributed amount is not.
If you are eligible to invest in a Roth IRA (but are not doing so) and are building an emergency fund, it’s worth considering combining these activities. It’s important to note that the principals of liquidity and security still apply, so the structure described above can still be applied to the Roth IRA balance.
There is no magic figure when it comes to how much is enough to hold in an emergency fund. Each individual’s situation is unique, from job prospects to living expenses. While no one can tell you how much should be invested, not investing in an emergency fund is a fiscal mistake.
Chad Fisher contributed this article on behalf of the team at http://www.secureinsurancequotes.com, who encourage financially prudent practices, from adequate insurance policies to emergency funds.