It’s important to save for a rainy day. In this guide, we give you ideas on where to put an emergency fund and how much you should save.
The world of personal finance is rife with oversimplified platitudes and one-size-fits-all advice. No where is this more evidenced than in the often-repeated advice about emergency funds.
Typical advice says that you should save three to six months’ worth of expenses in a high-yield savings account. Some financial gurus opt for eight months’ worth of expenses saved up, while others say four is enough.
Still others advocate for starting with a couple thousand dollars and beefing up the fund after you’ve paid off all debts.
How much you should have in an emergency fund and where you should keep it is more personal than this. In some situations, a smaller emergency fund may work just fine. And for some people, a low-interest home equity line of credit can be a reasonable emergency fund. In other situations, having this much cash on hand is a good plan.
But high-yield savings accounts are really providing barely enough to keep up with inflation. Stashing a ton of cash in a savings account may not be the best option. In this case, you might consider having a broader, more diverse emergency plan. This can help you make it through true emergencies without losing out on the interest your money could be earning.
If you’ve never thought through what you’d do in a financial emergency, consider creating an emergency plan that includes the following components:
1. “Mattress cash” stash
Clearly, I don’t actually mean hiding cash in your mattress, necessarily. But it’s not a bad idea to stash a small amount of cash around your home. If your ATM network is down for some reason and you need cash, you can get what’s in your home. I’m not talking about keeping a ton of cash in your home. This should be maybe two or three hundred dollars.
After all, in the case of a truly catastrophic world event, that cash won’t have much value, anyway. So we’re not really planning for that type of situation. This is more the type of situation where you’ve lost your wallet and had to cancel your debit and credit cards. You’re waiting on replacements, but you need to put gas in the car and groceries in the pantry right now. In this situation, you could make a couple hundred dollars work for a week or two.
2. Liquid account
Unless there’s a worldwide banking catastrophe, you should be able to access the next portion of your emergency fund within one day. You might consider putting this portion of your emergency fund into a money market or high-yield savings account. The idea is to earn as much interest as possible without losing FDIC insurance and easy access to your cash.
How much should you put into this fund? It really depends. The idea is that this should be enough to get you through from a job loss to the first paycheck at a new job. Many experts recommend having one to three months’ worth of expenses in this type of account, if not more.
The key here, of course, is that you’re saving expenses, not your actual income. If you make $4,000 per month but only have to spend $2,000 per month to meet your basic needs, you should use $2,000 as your monthly goal. So for three months’ worth of expenses, you’d only need $6,000 in savings.
Your thoughts for this portion of your emergency plan may differ, depending on your current situation. In a two-income family, for instance, you may not need as many months’ worth of savings. After all, the chances of both working adults losing their jobs at the same time are probably fairly slim. On the other hand, if your particular career suffers from an unstable job market, consider saving even more in this part of your plan.
3. Certificate of Deposit ladder
You can earn a bit more interest on your emergency savings if you use a short-term Certificate of Deposit ladder. With a CD ladder, you progressively invest in more certificates of deposit, which each have their own maturity date. As each CD matures, you can either pull out the money, penalty-free, to cover your expenses. Or you can reinvest it if you’re not in the middle of an emergency.
Combined with liquid savings, a CD ladder can be a good way to get through an emergency without losing out on slightly higher APRs. For instance, say you save three months’ worth of expenses in your liquid account. Then you create a CD ladder of three-month CDs. You’re then guaranteed to be able to tap at least one CD by the time you run out of liquid emergency fund savings. And if you need to keep pulling from the CD ladder, you can.
This way, you can take advantage of potentially higher CD rates, while avoiding penalties for withdrawing from your CDs early.
As you’re planning how to save for retirement, consider potential emergencies, too. In an emergency, you can withdraw your contributions (not your earnings) from a Roth IRA. Depending on your broker, these withdrawals could be free from penalties, taxes, and fees. Once the emergency has calmed down, you can contribute the withdrawals back into your Roth IRA.
You can also consider tapping into your taxable investments, if need be. This isn’t always the best option, especially if your investments are down. But if a true emergency, it can be a way to cover your expenses and potentially get some tax benefits while doing it. Remember, too, that if you sell when your investments are worth more than when they were purchases, you’ll face some tax implications. Just account for that when determining whether and how much to withdraw from your investments.
The best-case scenario is, of course, to have enough in liquid and intermediate savings not to have to tap your investments in an emergency. But understanding how this could potentially work is a good idea when you’re planning how and how much to invest.
One more item of note along these lines: do not rely on a 401(k) loan during an emergency. If you should lose your job, the loan would come due immediately. That just makes an already tenuous situation even more risky.
Using credit in an emergency can be a slippery slope. But it can be used wisely as part of a broader emergency plan.
For instance, if you’re currently paying hefty interest on credit cards, you should put your extra cash into paying them down rather than saving for an emergency. But you’ll want to be sure you don’t go back into high-interest debt if an emergency does arise. In this case, saving a couple thousand dollars to start can be helpful. This can help you get through unexpected car repairs or other smaller emergencies.
Then consider keeping open a home equity line of credit to use for larger emergencies. With today’s lower interest rates, you could finance a longer-term emergency without paying interest through the nose.
Another option is to keep your eyes open for credit cards with an introductory 0% APR on purchases. These cards are widely available to those with good credit. And you can often get one at the drop of a hat. This could get you access to a line of credit in an emergency. Hopefully the introductory offer would give you enough time to get through the emergency and then repay the balance before the introductory period ended. Luckily, credit card issuers are now offering these introductory periods for anywhere from 12 to 18 months, and sometimes more.
6. A bare bones budget
On an everyday, non-emergency basis, you probably have lots of little–or even large–expenses that you could cut out in a true emergency. It’s a good idea to know ahead of time what this would look like. Take a look at your spending for the past three months, and determine which expenses you could have cut with ease and which you could have cut with a bit of work or sacrifice.
This might include things like your cable subscription, other entertainment-related expenses, any dining out expenses, extravagant grocery-related expenses, and more. See just how much you could have cut out of your budget, and put that on paper. That’s your bare bones budget. If you had absolutely no money coming in, that’s how much you’d need to survive.
The exercise of writing down your bare bones budget is helpful for a couple of reasons:
- It helps you determine your emergency savings goals. Remember, saving for an emergency is about saving for essential expenses, not your normal, I-have-a-good-income spending. Writing down your bare minimum budget lets you see what you actually need to save for emergencies.
- It’ll give you a reference point in an emergency. When an emergency hits, you’ll be too busy looking for your next job or putting out the proverbial financial fires to think too much about basics like budgeting. So having this bare bones budget written down ahead of time can be helpful. You can use this document to know which services to cancel right away and how to budget until the emergency is over.
- You’ll see how much extra you’re really spending. Finally, writing down your bare bones budget is great even if you aren’t in the middle of an emergency. It’ll help you see just how much of your daily spending is truly necessary versus extra. While you don’t need to live on this strict budget all the time, it’s a good way to gauge if your spending is reasonable or getting out of control.
7. Stock up on essentials
I’m not advocating becoming a doomsday prepper, but having a stocked pantry and medicine cabinet can make emergencies easier to get through. And it’s not that hard to plan ahead. Just add a few extra cans of beans or other non-perishables to your cart each time you go to the grocery store. Shop in bulk for paper goods like toilet paper and paper towel. And keep your medicine cabinet well-stocked with first aid supplies, over-the-counter medicines, and such. And if you’re on any prescriptions, be sure to keep them up-to-date and refilled as often as possible.
These essentials may not get you through a several month long period of unemployment. But if you can get through the first month or two without having to buy more than milk and eggs from the grocery store, your emergency savings will go a long way. This is just a simple step to take over time so that you can cut expenses at the drop of a hat.
When you think about your emergency plan as more of a comprehensive plan, you’ll feel more prepared for potential emergencies. You’ll also know how to save for emergencies without your savings being eaten away by today’s still-low interest rates. Do you have a broader emergency plan? What does it look like?
Published or updated January 2, 2018.