5 Simple Rules: Keep An Emergency Fund

We’re continuing today with our list of five simple rules to help you make your financial life easier.  After yesterday’s advice to earn more than you spend, you should have a bit of extra money left at the end of each month.  One of the first things you should try to do with that money is

Keep An Emergency Fund

Actually, if you do much personal finance reading, you’ll discover that there’s actually two types of emergency funds that you need.  The first is designed to protect you (and your wallet) from sudden, unexpectedly high short term expenses.  For example, if your car breaks down or you need to go to the hospital, you should be able to cover the expense without having to put it on your credit card or sell off some of your investments.  This is a buffer fund, designed to keep your income flow buffered from the sudden expenses that life throws your way.

The sort of emergency a buffer fund is perfect for
The sort of emergency a buffer fund is perfect for

For longer term situations where your cash flow is decreased (or nonexistent), you need something more substantial.  The second type of emergency fund is really an unemployment fund, a sizable chunk of money that is easily accessed, safe from any (major) losses in value, and substantial enough to supply with living expenses for several months, at least.  This is what most people tend to think of when you mention the term ’emergency fund.’

In practice, these two types of funds can (and should) be used in conjunction with each other.  What you want is a step like arrangement of emergency funds, where each step contains more money, earning a little bit more interest, in a little bit harder to reach location.  As you use up the money in the preceding step, you move onto the next step, slowly drawing down the money you have available there to provide living expenses.  I like to think about the number six as I try to organize my emergency fund, as follows:

Emergency Fund Levels

Six Days of Expenses: Cash – Keeping nearly a week’s worth of your average spending in cash on hand.  You don’t have carry the full amount on your person at all times; a locked safe at home with a few hundred dollars in it would be an excellent idea.  That way, you’ll have a little money available for those sudden unexpected expenses, or if (knock on wood) you find yourself in a disaster a la the aftermath of Katrina, unable to reach a bank and unable to use credit cards to get needed supplies.

Six Weeks of Expenses: Bank Account – Once you’ve got a nice cash supply, the next step is put some money away into a regular, brick and mortar bank account.  This will form the basis of much of your financial life, and will also provide a ‘hub’ to which you can link other accounts (like an online bank or investment firm).  Most importantly for our purposes, a bank gives you a safe place to put some extra money, enough to cover your regularly monthly bills (and then some, hopefully).  This will form the bulk of your buffer fund, keeping you from living pay check to pay check and having to hope you can cash your latest check in time to cover the monthly expenses.

Six Months of Expenses: Online Savings Account or CD Ladder – The disadvantage of accounts with traditional brick and mortar banks is that they tend to have very low yields, regardless of whether you have a checking or savings account.  The cost of being able to run to the ATM or write a check against the balance in your account is a low interest yield.  Once you have enough money stored away to cover your monthly expenses, you can start trying to seek a higher yield for your money (while still keeping it safe).   Online savings accounts, like those for ING, HSBC, or Smartypig, make it harder to get your money (you’ll usually have to a wait a few days to transfer the funds), but offer a much higher yield than most traditional banks in exchange.

Once you have a sizable amount of savings, if you want to boost your return even more, you can opt for a CD ladder.  Essentially, you’ll buy CDs of varying maturities, attempting to arrange your money so that each month, a CD with one month’s worth of expenses will mature.  You’ll be able to (usually) get a higher interest rate than with a straight bank account, without much added risk.  Be careful though; if you need to get the money in a CD before if matures, you’ll usually pay a stiff fee.  Be sure that you have enough money in other, more accessible accounts to cover any foreseeable (and some unforeseeable) expenses you may incur.

(Up To) Six Years of Expenses: Other Cash Equivalents – Once you’ve gotten the previous steps complete, you might be ready to call your emergency fund finished.  Six months is a pretty sizable emergency fund, and if you’ve been high-balling your expected expenses, six months should cover you pretty well.  But perhaps you want even more money set aside in your emergency fund because you have a large family to support, or you’re approaching retirement and will soon be using your ’emergency’ fund to provide your regular living expenses for decades to come.

In those cases, you’ll be best served by looking into some the higher yielding but still fairly safe investments, allowing your cash a chance to grow at a faster clip than any of the previously mentioned locations without too much risk of it dropping in value.  One possibility is money market funds, mutual funds that invest in highly safe and steady short term investments.  They frequently yield more than regular bank accounts (although, as of this writing most money market funds have essentially zero yield) with only a tiny chance of losing money.  If you’re in a retirement account, you can also consider a stable value fund, which has as its goal keeping the value of your investment safe while still earning a yield (however low that might be).

For those willing to take a little bit more risk to get a higher yield, there are other reasonably safe options.  Short term bond funds, for example, have much higher yields than money market funds.  In the event that interest rates start to rise, though, short term bond funds will decline in value, at least temporarily, while money market funds almost certainly won’t.  If you have a substantial amount of money in the other parts of your emergency fund, though, you might be willing to take that chance in exchange for the higher rates of return offered.

There you have it, how to build a sizable and complete emergency fund.  It’s a bit trickier than you might have guessed (at least, if you want to be ready for any emergency), but still fairly easy to do.  The piece of mind it can bring is hard to understate, though.

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