Emergency Fund Basics
Updated: May 5, 2020
Most people know that an emergency fund is important, but there is a lot of confusion about how much money you should have in your emergency fund and where it should be placed. However, there is no one right answer. Despite that, in this post, we are going to discuss some common recommendations.
How Much Should I Have In My Emergency Fund?
Surprisingly, most professionals recommend the emergency fund to be built in two different phases as described below.
First, it is commonly accepted that you should build up an emergency fund of $1,000 dollars before paying off all high-interest debt. While this might seem backward, creating a small emergency fund from the get helps in various ways. Obviously, the fund gives you the ability to pay cash for emergencies instead of accruing more debt, but in addition to that, it has a psychological benefit. With this emergency fund, it is going to give you a little more sense of stability, a sense that you are on the right path, and a sense of motivation to keep moving forward.
Now, before building your emergency fund in the second phase, it is recommended that you pay off any high-interest debt. High-interest debt is commonly any debt above around 5-7% APR.
Once you have paid off all high-interest debt, it is time to finally finish your emergency fund. Typically, professionals recommend having 3-6 months’ worth of expenses saved in your emergency fund. Now, this will vary from individual to individual based on their risk tolerance, annual income, and spending habits. However, this 3-6 month range is a solid rule of thumb to follow.
Where Should I Put This Money?
Well, the risk-free option is to stock this money away into a savings account. While it won’t earn you much money, if any at all, you will know that it is sitting safe, and for those you are extremely risk-averse, this would be a great option. I would recommend finding a high-interest savings account if possible, to at least gain some return on your money.
Another popular option is putting your money into a money-market account. Overall, these accounts will return modestly, but it is extremely unlikely to lose large sums of money in them, which is extremely important when trying to keep money safe.
The third option is putting this money into CDs. While this money will not be liquid without a penalty, it could be a decent option if you want a decent return on your money while keeping the money safe.
Where To Go From Here
If you have not built your emergency fund yet, it is extremely important to start that endeavor immediately. You should start by creating a budget and portioning out part of your income to your emergency fund. On the other hand, if you already have your emergency fund in place, double-check where your money is being placed, and if it is working to the best of its abilities for your needs.
Disclaimer: I am not a financial advisor, so please review all of this advice with your CFP or financial advisor first.