How to Build An Emergency Fund

What's an Emergency Fund?

Everyone knows the word 'emergency', but in the context of personal finance it's worth understanding what we mean by an emergency. A financial emergency could be the loss of a job, unforeseen medical bills, car or home repairs, or anything else that could happen to you or your property that you'd want to have some cash on hand for.

If you're investing efficiently, it's best to only have the cash to cover your standard expenses and a bit extra that you might really need in a pinch if a few things went south at the same time. The rest of it should be growing on it's own while you keep adding more to the pot.

How Much Should I Set Aside?

This is going to be somewhat unique to you and your situation. Here's the approach I would take:

1. Figure out your expenses. By now you're probably familiar with Mint as a great tool to organize and track all of your finances and expenses automatically. Figure out how much you spend per month on rent/mortgage payments, groceries, restaurants, entertainment, travel, etc. Take that number and add a little head room (say, 15%) so it's sure to cover an above average spend you might have.

2. Decide how much to start putting aside. I've heard everything from one month of expenses to six months, a year or even more. I'd recommend take it in phases, start with one month, then build it to three months, six months, and perhaps even a year. I'm pretty conservative, but I wouldn't go beyond a year. That constitutes a pretty massive emergency, and you're likely to have other ways of addressing it besides having a bunch of cash sitting around earning very little interest.

3. Be disciplined about where the money goes. Put anything earmarked for your emergency fund into a separate account that you never use for payments of purchases. It should be accessible, but not co-mingled with the rest of your money.

Where should my emergency fund live?

There are a few schools of thought on this, but here are three common ones:

Bonds/Other Investments: Some say it's fine to put your emergency fund in bonds or other "low risk" investments and pull from that if you ever need to. Bonds don't fluctuate much in value typically so they're a pretty stable, liquid way to hold these funds. Sometimes though, they can fluctuate a lot, like they did in 2008. The "other investments" option could be index funds, dividend stocks, or other vehicles. I'm not a big fan on this approach because it mixes your emergency fund in with your investments so it's hard to be disciplined about keeping it separate and if you had to sell something that increased in value, you'd likely be subject to taxes. Others say use your Roth IRA contributions as an emergency fund because these can be pulled out without penalty, but I'd rather leave everything I can in the Roth to grow for as long as possible and keep emergency funds outside of tax advantaged accounts.

Checking account: You can set up a separate checking account for your emergency fund at the same bank you use normally, or another one. You can keep that debit card in a drawer and if the unexpected strikes, you're ready to call on your emergency fund for help. This is a good approach because the funds are very liquid, but checking accounts earn very little interest typically so you can do better elsewhere.

Online Savings/CD: This is my favorite option and the one I chose for my emergency fund. There are a bunch of online banks that have way better interest rates than brick and mortars like Chase and Bank of America. When I first started by emergency fund, I went with an Ally Bank Online Savings Account. The interest rate is about as high as you'll find on a savings account these days, the online portal is slick and easy to use, and it's free and fast to open an account that's fully insured by the FDIC. 

Recently, however they've been offering an even better interest rate if you open a No Penalty CD account with at least $5,000 (the rate is even better if you put in $25,000). The way it works is that your account earns interest over an 11-month period and then you get paid at the end, the thing is, with a no penalty CD you can close it at any time, get all the interest you've earned to date and pay no penalty. In practice this means that you get the same liquidity as any standard savings account but an even higher interest rate. It felt like a no-brainer so my emergency fund is in one of those instead. If I ever need to pull from it, I can just close the CD, collect my interest, take what I need, and open up a new CD with whatever is left once the emergency subsides. It's all done online in a matter of seconds. Easy.

Whatever you choose to do, having your emergencies covered is a wise move, so if you haven't already got it covered, get on it!

Keep Stacking,

BS