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The cardinal rule of an emergency fund is that it should cover your expenses for three to six months. This might seem like a modest goal, but when you add up your daily expenses, the amount can seem daunting.
There’s always the possibility of facing something massive, like a medical emergency, that could make you unable to work. In a situation like this, many daily expenses would be considered optional instead of necessary.
Just remember that the purpose of an emergency fund is to cover your essential costs only. The remaining optional expenses (like going out to eat) should not be included in your emergency fund.
Drawbacks of an Excessively Large Emergency Fund
Look, there’s nothing wrong with saving too much money. However, we need to keep the right amount of money in the proper accounts.
If we don’t, we’ll face several disadvantages. Putting too much money in your emergency fund can actually lead to drawbacks. For instance, many of us keep our emergency funds in a savings account. These accounts typically offer a low interest rate, which can lead to potential problems.
Then there’s inflation. You probably already know that inflation erodes the value of your savings.
So the interest rate you earn on your emergency fund should be higher than the inflation rate to grow the real value of your money. If the interest rate is less than the inflation rate, your money will lose its real value.
The other major drawback is that you’re channeling too much money towards less-lucrative accounts, rather than profitable retirement accounts that offer tax benefits.
This creates a significant opportunity cost. It basically means you’re losing potential earnings.
How a Large Emergency Fund Could Keep You from Growing Your Wealth
So it’s definitely possible for an emergency fund to stop you from growing your wealth. Let me give you an example to illustrate.
Say you invest $20,000 in an account that earns 2% as your emergency fund. All other factors excluded, you’ll receive a modest amount of $400 annually.
Had you instead invested this amount in a more profitable retirement account, you could have earned around three to four times this amount. Compound this over a few years, and it becomes exponentially more appealing.
How to Calculate the Optimum Size for Your Emergency Fund
Conventional wisdom says that you should save enough so your emergency fund lasts for three to six months. Please note that emergency funds should provide for three to six months of necessary expenses, NOT your current income.
Another critical aspect to consider is the period. There is a significant difference between saving for three months and saving for six months.
So, you have to pay attention to a few different factors to determine how long your emergency fund should last.
If you’re the sole income-earner of your household, for example, you should probably aim for the upper end of this range: six months. If your job fluctuates according to the economy or is seasonal, likewise, aim for six months.
Do you have multiple income sources?
This is an important question. Multiple sources provide greater income security.
For instance, suppose you have three income sources: your job and two side-hustles (which is actually pretty standard these days).
If one income source dries up (i.e., you lose your job), you can still earn from the other two sources (provided they are not connected to the first income source). So, with more than one income source, an emergency fund closer to three months is probably feasible.
Similarly, if more than one person is earning money for your household, then you can aim for closer to three months. Just remember that this will vary on your specific situation and risk tolerance.
Also, keep a close eye on your daily expenses. If you follow a budget, you’ll have a good idea of your spending needs.
Focus on your necessary expenses (i.e., housing, food, car, clothes) rather than the optional or luxury expenditures (i.e., going out to eat, vacations).
Remember, your emergency fund is meant to cover necessities, not luxuries.
In an emergency situation, you’ll have to get by without discretionary spending. Again, this includes costs like shopping, restaurants, entertainment expenses, and cable.
Internet, once considered a luxury, is now a necessary expense since it’s now an integral part of our lives. You need it for everything, from daily communication to job search and several other important uses.
Here are some of the expenses I believe your emergency fund should cover:
- Debt payments
- Insurance premiums
- Medical bills
- Car loan installments
Add up all of these expenses, and any other necessities, for one month. Then, multiply this amount by the number of months that your emergency fund should last. This is the amount of your emergency fund should hold (give or take a few hundred dollars).
How to Determine If You Have Too Much Money in Your Emergency Fund
To determine if you have too much money in your emergency fund, simply calculate the optimal amount of the fund as previously described. If your emergency fund is higher than this amount, then it’s too big. You should withdraw the surplus amount and stick it in your investment portfolio.
How to Cover Sudden Costs with Emergency Funds
To cover unexpected costs with your emergency fund, you’ll need cash on hand to deal with things like a job loss. Having cash on hand is necessary for required payments.
You can’t rely on your credit card every time. For instance, your credit card can’t be used for mortgage payments (I mean, it can, but it’s a terrible idea in this situation).
You should also increase your emergency fund to cover impending costs. For instance, if your roof is reaching the end of its life expectancy and needs a significant rework, your emergency fund should include this amount.
But there may also be unforeseen expenses you have to pay for. For instance, your dog may need emergency surgery. Should these costs be included in your emergency fund planning?
That exact situation happened to me a few years ago when we had to have our dog’s teeth cleaned. It turned out his teeth were so bad, they had to be extracted, and it cost over $1,000.
Including all these types of costs can make your emergency fund excessively large. Some of these events have a low chance of occurring or may never happen.
So it’s better to have a source in place that you can draw upon for these kinds of scenarios. This is going to be different for different people and situations, remember.
If you use YNAB, for instance, you can plan ahead for these types of things outside of your general emergency fund. Or, if you can manage it, keep a credit card with a high credit limit for sudden, unexpected expenses.
I’ll be obvious at this point about one key advantage of an emergency fund:
It can be a valuable tool to avoid substantial credit card debt.
Make sure you’re careful with credit cards; otherwise, they will keep adding to your debt quickly. Use your credit card wisely, like for emergency payments.
If possible, make sure you pay your bill in full, so you avoid interest. If not, find a card with a low (or promotional) rate and set a plan to pay it off in a specific period.
If you don’t, you may be counteracting your emergency fund entirely.
Here’s another tip for using credit cards:
If you use your credit card for unforeseen emergencies, you’ll need to come up with a way to pay off the balance quickly. One way to do this is to divert a few month’s worth of your savings contributions towards paying off the debt.
This kind of occasional use of your contributions will have a minimal negative impact on your savings over time. You can also cut down on discretionary expenses and live a little more frugally for a while.
Put the Extra Amount to Good Use
If you find you have too much money in your emergency fund, you should draw the excess amount and invest it in an IRA. Currently, contributions of $5,500 per year may be invested in an IRA. If you’re over 50, you can contribute up to $6,500 each year.
How to Invest Your Emergency Fund
If you invest your emergency fund in a savings account, you’ll earn a relatively small amount due to low interest rates.
Many savings accounts are paying around one to two percent interest. You can find some paying over 2.00% APY, but it’s not common. This moderate amount isn’t even enough to cover inflation.
We’ve seen these types of low rates of return for about seven years now. This has led savers to reconsider putting their emergency funds into savings accounts entirely.
So what should you do then with your emergency funds? There is a difference of opinion between investment experts.
Some experts believe that emergency funds should be invested in a portfolio which allocates between 30% – 50% to stocks.
Other experts are opposed to this idea.
According to others, emergency funds should not be invested in portfolios containing stocks. They’re concerned about the stock market risk and its impact on your funds.
Experts who advocate putting emergency funds in portfolios argue otherwise. They say that risk is everywhere, not just in the stock markets. Even the money in the savings accounts is not safe from certain risks.
The most significant risk to the savings accounts is inflation. It erodes the value of your savings without you even realizing it.
The insidious nature of inflation makes it even more detrimental. The biggest problem with inflation is that it’s hard to quantify its adverse effects on savings.
So what happens is we become complacent, and we get a false sense of security from our savings accounts, due to the apparent marginal increase in our savings each year.
However, the negative effect of inflation may be more significant. The problem is that the adverse effects of inflation do not manifest themselves as losses in our savings account balances.
Meaning – we can see our account values drop when it’s invested in stocks. We can’t see this with a savings account being impacted by inflation.
Therefore, experts advise us to know we are losing a certain amount of our savings account to inflation each year. We need to accept and understand this.
So we need to look for ways to offset this loss and prevent our savings from diminishing in value. Every year, the cost of living and utilities will increase, but our savings account balance will probably not grow at the same rate.
Are there any better options than savings accounts or stocks? Before looking at the alternatives, ensure that you understand the concept of liquidity.
Liquidity is a desirable attribute of an asset. With high liquidity, you can easily convert the asset to cash.
But high liquidity can also be a double-edged sword. Higher liquidity implies lower earning potential.
Besides liquidity, another factor you should look out for is withdrawal penalties. Be able to easily withdraw your funds when needed incurring no penalty.
Are Bonds Suitable for Emergency Funds?
Stocks can be risky. What about bonds then? Does their lower risk make them a safe option?
Bonds are not that great of an option. Although they are less risky than stocks, they still carry too much risk to be suitable for your emergency funds.
I’d suggest looking for better options for your emergency fund.
Here are the Best Ways to Invest Your Emergency Funds:
1. Money Market Accounts
One idea for your emergency fund is a money market account, which allows you to withdraw funds via checks or a debit card. Not only are these accounts relatively safe, but they also offer an interest rate higher than savings accounts.
Make sure that the account is insured by the FDIC. Most money market accounts are. Even accounts not insured have an excellent track record and pay a relatively good interest rate.
Look for online banks that allow you to draw checks or use a debit card. This is great for withdrawing money when you need it.
2. Online High-Yield Savings Account
You can also turn to an online high-yield savings account to store your emergency funds. Not only do these accounts pay more interest than the traditional savings accounts, but they are also insured by the FDIC.
Online banks offer higher interest rates because they are not subject to overhead costs like traditional banks.
Know about the methods of making withdrawals from these accounts. For instance, with Ally Bank, you can make check request, telephone transfer, outgoing wire transfer, and online funds transfer to access your money.
There are also other methods of withdrawals, but they can take several days. This will defeat the purpose of an emergency fund. So know about quick withdrawal methods.
Also, look out for certain traps. For instance, some accounts offer great introductory interest rates.
Unfortunately, these interest rates come down to fair values quickly. You should avoid these types of accounts. Shop around for accounts which offer a consistent and reasonable rate of interest.
3. Certificate of Deposit (CD)
These deposits can provide a fair amount of interest. However, they have one major problem: If you withdraw before the maturity of the CD, you’ll incur a penalty. This will reduce your gains.
Another problem is that CDs with the highest interest rates also have the highest maturity periods. The maturity period can go up to five years for CDs that offer the best interest rates.
Despite penalties, CDs can offer better returns than online savings accounts. Here is how it works:
Suppose that the penalty for early withdrawal from a 5 year CD is an interest amount worth six months. If you liquidate your CD before six months, you’ll lose a certain amount from your principal.
But what if you wait for 3 years, for instance?
Depending on the interest rate of the CD, your gain may be more than online saving account or money market gain even after incurring early withdrawal penalty. Also, CDs are insured by the FDIC.
Certain banks offer CDs without early withdrawal penalties. However, they also provide a lower rate of interest.
You can also minimize your early withdrawal penalties by creating a CD ladder. Instead of buying one large CD, you can purchase many small CDs which mature at different time intervals.
4. Roth IRA
People are reluctant to put money into retirement accounts because they incur penalties for early withdrawal. Therefore, retirement accounts don’t always appear to be suitable for emergency funds.
However, a Roth IRA can solve your early withdrawal woes. With a Roth IRA, you only pay taxes on your contributions.
Since your contributions are taxed, the withdrawals are tax-free. You can, therefore, withdraw from your Roth IRA without incurring a penalty.
To avoid the 10% penalty, only the earnings must remain in your Roth IRA till you’re 59 years old.
You’ll first have to check if you qualify for a Roth IRA. If you do, you can use the Roth IRA as second account for your emergency savings.
Depending on income limits, you can save as much as $6,000 annually in your Roth IRA for 2019. If you’re a married person, you and your spouse can contribute up to $12,000 during 2019.
This article discussed a simple way to calculate the right amount for emergency savings. It also shows how you can invest your emergency fund to ensure that it grows in value rather than being diminished by inflation. Finally, the article shows the best ways to save your emergency funds for maximum liquidity, highest return, and lowest risk.
Now that you have a better idea of how to manage your emergency fund, how will you get started saving?