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Where should you keep your Emergency Fund?
Well, I’m not sure whether this is a good day to write this article or a week or so too late. At the very least, it will be easy for me to find an example and will probably make my argument easier. I have had this post on my list for almost two months – I now wish I would have posted it sooner.
I was having a conversation with a friend a while back and (as most of my conversations seem to do) it turned towards financial topics. He asked me if I thought it was really necessary to keep your emergency fund in a liquid account – like a savings account. He told me that he didn’t see any reason to keep it all in a savings account. Instead, he liked to keep most of his money in the stock market. He reasoned that he can withdraw the money from his account at any time and have access to that money within a week.
Conventional wisdom says keep your emergency fund in a safe account
Most of the time you will hear conservative financial personalities (like Dave Ramsey) tell us that an emergency fund should be in a simple savings account. In fact, Ramsey goes so far as to say that the money should be absolutely safe and absolutely easy to withdraw. Earning interest, he says, is not the point of that money; it must be there if and when you need it. But is the conventional wisdom correct in this case?
Personally, I agree with the conventional wisdom
In discussing this with my friend, the scenario I described to him was as follows: Imagine that the economy is not doing so good. Say that the stock market just decreased by 20%. And since the economy is not doing well, you lose your job. So, you’ve just lost your job and now your emergency fund is 20% smaller at the exact moment you need it. That was my "worst case scenario" as I described it to him. Unfortunately, reality is even even more grim at this point in time with many jobs being lost due to our struggling economy (have you noticed how most of the current problems with the economy are related to debt in one way or another?) and the US stock markets are down 40% from a year ago. So, if you’ve lost your job recently and your emergency fund is now only a bit more than one-half of what it was last year, you are hurting!
But what about the opportunity costs?
My friend countered that he could tolerate the 20% loss because he would have made 40% in the market during the good times. He felt like leaving the money to sit basically idle in a savings account would cost more money in the long term. This argument is reasonable but, to me, is a bit risky. Certainly, I do not advocate putting all of your money in a savings account. I am definitely in favor of investing most of your resources for the long-term. I just think that the emergency fund portion of it should be safe and readily available.
This argument is just semantics
Remember that the typical range bandied about for an emergency fund is 3 to 6 or even 8 months of your expenses. That is a huge range! So I think this argument comes down to how risky you want to be with your money. If you are saying you want to put most of your emergency fund in the stock market, I would say that money is not really part of your emergency fund. You are actually preserving a very small emergency fund and taking on a bit more risk than someone with a full 8 or 12 months of expenses in a savings account.
Like a lot of things, it comes down to risk
Maintaining a small liquid emergency fund while putting more of your money in the stock market introduces a higher risk than having a larger emergency fund. If you are comfortable with that risk, then that is a fine decision for you. For a single parent, it is probably not prudent to take on a lot of risk if it is possible to avoid it. I work full-time (and I blog, of course) and my wife works part-time, so having a smaller emergency fund is not as risky for us.
I would just caution you to be honest and realistic about your need and your tolerance for risk. Warren Buffet has said that if you aren’t comfortable with possibly losing half of your money, then you shouldn’t be invested in the stock market. This is even more critical for an emergency fund where you could need the money at any time as opposed to a retirement account that is decades away from being tapped. Markets do go up but remember that they also go down sometimes (and as we saw last week, they can go down frighteningly fast).
Keep it safe
My advice would be to decide how much you are really comfortable having for an emergency fund and keeping that in a safe, ordinary, boring (but FDIC insured) savings account. Personally, I use two online savings accounts – EmigrantDirect (currently 3%) and ETrade (3.3%). (Update: Etrade currently has a deal where you can get $25 for a referral sign up – if you’re interested, drop me your email address and I’ll send you an invite). You won’t make any money on it (although I’ve made a lot more money this year in my savings account than my mutual fund accounts) but that’s not really the point. Remember, it’s an "emergency" fund, not a "making lots of money" fund. Putting it in the stock market is not going to make you rich but if it’s not available if you need it, that decision might just make you poor.
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5 Responses to “Where should you keep your Emergency Fund?”
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I agree about your point that it should be safe money. I think putting it in stocks defeats the whole purpose, like you mentioned in your worst case example. Because I am a bit more tolerant of risk than some, I have split my emergency fund. So, say half of it is in a high yielding savings account and the other half is in a higher yielding short term CD. I figure most emergencies can be handled by half of it in savings, and if it is a big enough emergency, it won’t be a big deal to bust out of the CD early and would only cost me a few bucks in lost interest.
I keep mine under my mattress.
I really like Consumerism Commentarie’s line of thinking of spreading your emergency fund out. My thoughts are to put $1000 in a super easy and accessible area such as a bank savings account linked to your checking.
Then put a months worth of expenses in something like one of the high interest online bank accounts.
Finally put 3 months worth of expenses in some sort of index fund. This can be pulled out in times of dire emergency, but in reality, you should never have to touch it and you can just let it accumulate into 6 months or more worth of savings. If the market crashes (like it did a week ago) you should still have at least a few months worth of savings to pull out on top of the other 2 savings accounts I listed in case of such an emergency.
The big thing I would warn against is using the stock market too much as a basis for an emergency fund. When the economy is at is lowest is when the highest likelihood of a layoff to occur, thus creating an emergency when your stocks (and your emergency fund) are taking the greatest hit. They work against each other that way.
Thanks for the tips, guys. I am actually very conservative with my emergency fund and just have it all in an online savings account. When it was earning more than 5% it was a no-brainer – it was very safe and earned a decent rate as well.
@WiseMoneyMatters – do you use a stock fund or a bond fund?
@ChristianPF – have you found short-term CD rates that make it worth the extra hassle?
Again, with fair warning, remember to make sure that your savings vehicle is FDIC insured. You will need to check with your particiular bank or brokerage office to find out, but not all are the same, so read the fine print.
BTW – ING still seems to have the most versatile savings accounts and online checking, all of which are FDIC insured, but they have recently lowered their interest rate and increased the time on funding.
Emergency fund should be keep in safe so that every time you look at it, it will be easier for you. Saving in an emergency fund is a necessity compare of buying luxuries. Since every countries economy suffers due to recession we should be more optimistic.