What Is an Emergency Fund?
No matter if you call it an emergency fund, a safety net fund, or a reserve account, the idea is that we all need extra money set aside to stay safe from the unexpected.
I’m sure you can relate or imagine how you’d feel if your car wouldn’t start, you got a huge dental bill, your refrigerator quit working, or you lost your job or business income. If you don’t have a financial cushion to fall back on for a large expense or a sudden cut in income, a crisis might take years or decades to recover from.
So, don’t let yourself get backed into a corner, financially speaking.
Having enough money at your fingertips for emergencies should never be thought of as a luxury. Building up a reserve should be one of your top financial priorities.
How Much Emergency Money Should You Have?
So, how much emergency money should you have? While no one can predict the future, I recommend that you have enough to cover your living expenses for at least 3 months.
Living expenses are just the basics, such as housing, utilities, groceries, and loan payments, and are not necessarily a full replacement of your income. For instance, if you could get by on $3,000 per month if you lost all your income, then always keep a minimum of $9,000 ($3,000 x 3 months) in reserve.
But having a reserve of 6 months or more is even better since finding a job could take that long, depending on your industry. It’s a good idea to evaluate your needs and adjust your emergency fund goal as your life and working situation changes.
The Difference Between Saving and Investing
Investing money means you could get relatively high returns, but that you could lose some or all of it.
Even though we tend to use the terms saving and investing interchangeably, they’re not the same thing. The difference has to do with taking financial risk.
The purpose of saving money is to keep it safe and free from risk so you’ll have it for emergencies and planned short-term purchases. The purpose of investing money is to increase your net worth and to achieve large, long-term financial goals, like retirement.
Remember the huge tradeoff between financial risk and return. Investing money means you could get relatively high returns, but that you could lose some or all of it.
Think about what would have happened if you lost your job in 2008 when the financial markets took a dive. If your emergency fund had been invested in stocks, the value would have plummeted and you could have been left with a tiny financial cushion.
On the other hand, you won’t lose money in an FDIC-insured savings or money market deposit account, no matter what happens in the markets, but you won’t earn much. Even though savings accounts pay a low interest rate that may not ever keep up with inflation, that’s the price you pay for keeping money completely safe.
The goal is to make sure you always have enough money to protect yourself from an unexpected emergency—not to earn high rates of return or be subject to market volatility.
Should You Invest Emergency Funds?
Since you don’t know whether you might need to tap your emergency fund next week, next year, or in 10 years, I recommend that you keep your 3-month living expenses amount as pure savings. Once you save more, you can consider investing amounts above that threshold.
Brittany didn’t mention her household income or monthly expenses, but let’s say their living expenses are $6,000 per month. In that case, their emergency fund of $40,000 would last over 6 months.
My recommendation is that they keep at least 3 months’ worth, or a minimum of $20,000 in their current savings account. If she and her husband both feel strongly about getting more return on the remaining $20,000 (even if it means taking on more risk), they could consider some conservative investing options.
Where to Invest Emergency Funds?
One suitable place to invest emergency funds is a short-term CD or certificate of deposit. They give you a guaranteed rate of return, but don’t allow you to access the money during the term, such as 3 months, 6 months, or 5 years.
In general, the shorter the term the less a CD pays. So only put your emergency money in a CD if it pays much more than your current savings rate.
Other conservative or moderate-risk investing options include mutual funds or exchange-traded funds. First, you’d need to open up a regular, taxable brokerage account to buy them.
Stock funds are the riskiest type of fund, so look for more conservative options, such as balanced funds or bond funds to get some account growth, while you keep it fairly safe from potential losses.
How to Build Your Emergency Fund
If you haven’t started saving for an emergency fund, accumulating 3 months’ worth of living expenses can seem daunting. Depending on your income and financial situation it could take years to achieve.
Don’t worry; just get started by taking small steps every month. Make a goal to accumulate $100, then $500, and $1,000, as quickly as you can. Yes, this might require some sacrifices to reduce spending or earn more money.
Here’s a quick and dirty tip if you’re not a disciplined saver: automate it.
Ask your employer to split your paycheck between your regular checking and your emergency account. If you get a paper check or are self-employed, set up an automatic transfer from your checking into your emergency savings fund.
Once you have a safety net in place, you’ll have an amazing sense of security and peace that no matter what happens in your financial life, you’re prepared to tackle it.