I write a lot about the emergency fund (i.e. rainy day fund) on PT Money, but it just occurred to me that I hadn’t actually written a post on starting one. Now, I did detail how we put our savings in a high-interest savings account. That post could easily be titled “open up your emergency fund in a high-interest savings account”, because besides our property tax savings, those “savings” are essentially an emergency fund.
But strictly speaking emergency funds, you could use a number of methods and types of accounts to hold your emergency savings in so I’ll discuss those here. I’d also like to cover other aspects of emergency funds, like why you might want to have one and what key elements make up a good one.
What is an Emergency Fund
Wow, I said “emergency” a lot in that first paragraph. Sorry about that. Truth be told, I’ll likely say it often in the rest of this post so just bear with me. OK, let me first start with this: I knew nothing of emergency funds until I started listening to Dave Ramsey’s radio show. I mean, I knew about having savings, but I didn’t know to call it an emergency fund. So, thanks Dave! I think calling your short-term savings account an emergency fund is a good way to motivate you to have one, because it gives you a clearly defined goal for that money. It also motivates you to have a nice-sized one.
My definition: An emergency fund is money that you set a side (a few months of your expenses) to be used only in an emergency. It’s like a fire extinguisher for your personal finances.
The fund is typically made up of three to six months of your expenses and is typically held in a place separate from your normal spending account.
Why You Need an Emergency Fund
A good place to start this discussion is to decide why you might need one of these funds. The reasons basically break down into two main categories: you could have an unexpected loss of income (i.e. lose your job, get hurt or pregnant and can’t go to work for a while) OR you could have an unexpected expense (i.e. your car breaks down). Since most people aren’t insured against every type of event that could happen, an emergency fund ends up being an excellent choice for just about everybody. Do you have one?
Key Elements of a Good Emergency Fund
Big Enough – Your fund should be big enough to help you through those events I just mentioned above. For example, if it would take you one to three months to find another job if you were to lose your current one, then plan on at least having an emergency fund of three or four months of your expenses. What expenses? Plan on spending the bare minimum during your down time (i.e. cut the cable, don’t dine out as much, etc.). I’m pretty conservative (I think) and aim to keep about 10K in a fund. That would keep me going well above the bare minimum expenses until the three or four month mark.
Accessible, but Not Too Accessible– The fund should be kept somewhere where you can get to it in your time of emergency. But I tend to think it should be kept far enough away so that you can’t spend it on day-to-day spending. This means, don’t keep it in your safe, regular checking account, or the savings account attached to that checking account. On the flip side don’t use a CD to hold your emergency savings either. CDs mature on a monthly basis at the earliest and so if you needed it right away, I’d expect that you’d pay a penalty for withdrawing your money early. Of course, you could use several CDs and have them in a revolving maturity schedule. That way part of your money would become available every month. That’s still not flexible enough for me though. I like the middle ground of the high-interest savings accounts: it usually takes only a couple of days to get your money from them. Perfect for most emergency situations.
Making Money for You – Lastly, as a bonus, you’d like your emergency fund to be earning money for you and keeping up with inflation. There are many online savings accounts that are FDIC insured where you can earn a few percentage points of interest on your money. That can add up quick. The account I use is the 360 Savings Account from Capital One 360. I highly recommend it for it’s user friendly interface, ability to create multiple savings accounts, and assess to variety of related products (i.e. checking, CDs, brokerage). To see this account compared with several other options, visit my high-yield online savings accounts page.
Keep those three elements and your main goals in mind and you should have no trouble setting up the appropriate emergency fund. Good luck.
Photo: by Jam Adams