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Written by: Patrick Marcinko | Bogart Wealth
Emergency Funds Explained
Life happens and emergency expenses can sometimes occur at what feels like the worst time. We have no way of knowing when they will happen, but we do need to plan for the unexpected. Having a well-funded emergency fund is one of the best ways to protect yourself financially.
An emergency fund is money set aside for unexpected cash needs. These expenses can be from major life events like losing a job or medical emergencies to smaller things such as home repairs or car issues. What can make these expenses challenging is that they can’t be budgeted for and can throw a major wrench in your finances.
The Importance of Emergency Funds
Bankrate recently did a survey finding that over half of Americans cannot cover a $1,000 surprise expense.1 These expenses can happen at any time but considering the current economic uncertainty, they may become more common. If you find yourself faced with an emergency expense and don’t have enough cash set aside to cover it, it’ll likely be a headwind for your financial goals but also add stress to the situation. This can have a snowball effect where after the first expense, it can leave you less prepared to handle another emergency.
The role of an emergency fund is to build a buffer so that when money is needed unexpectedly, it is available to pay for the expense, and help you better respond to the situation. The emergency fund helps provide peace of mind in knowing there is money to cover the expense, and you can put more energy into working on the issue.
The purpose isn’t to grow, invest and multiply the money in an emergency fund. The money is an element of financial protection that will help keep you working towards your financial goals, even when the unexpected happens. The best way to continue to save and invest for the future is to make sure that you have a strong defense, that starts with an emergency fund.
How much to save for emergencies
The size of your emergency fund is unique for everyone. It is common to have enough set aside in an emergency fund to cover between 3 to 6 months of after-tax expenses. For those with one income, it might be best to have closer to 6 months of expenses saved. Consider expenses like housing, transportation, food, credit cards and other debt when determining how much money to set aside.
Best places to have your emergency fund
One of the most important aspects of an emergency fund is that the money is there when you need it. The money set aside is not supposed to be an investment. For example, let’s say the emergency fund was invested in XYZ stock mutual fund and that fund is down when you go to use the money. Not only will you be forced to sell while the market is down, but now you may not have enough to cover the expense. The money needs to be there when you need it, the hard part is, you don’t know when you’ll need it so keep the money somewhere with low risk.
High Yield Savings Account
One of the best places to keep money as an emergency fund is a high yield savings account (HYSA). These accounts have blossomed in popularity over the past few years and typically offer much higher yields than traditional banking accounts. Most HYSA are FDIC insured, meaning that they are insured up to $250,000. When evaluating various HYSA, consider account fees, deposit minimums, and of course, the interest rate.
Credit Cards are NOT an Emergency Fund
There is a misconception that all unexpected cash needs should be covered by a credit card and that will serve as an “emergency fund.” While a credit card can be valuable, it should not be the first line of defense for emergencies.
The reason is because credit cards carry very high interest rates. If a large expense gets charged and the balance carries over, the interest can quickly accumulate. These interest rates can exceed as much as 20%. Additionally, carrying a balance can negatively affect your credit score if your credit utilization rises too much. Each credit card has a credit limit or the total amount the credit card company is willing to lend you. Your credit utilization is the amount you’ve charged divided by the credit limit. For example, if you had a $1,000 credit limit and charged $250, then your credit utilization is 25%. It is recommended that your credit utilization be below 30%, anything above could hurt your credit score.
Credit cards should not be the primary resource for all unexpected cash needs, rather they should be viewed as a last resort. If you find yourself short of cash and with an emergency expense, a credit card can be a way to cover it, but it is important to develop a plan to best pay off the debt.
Money Market Funds
Another place to have money for emergencies is in money market funds. These are a type of mutual fund that invests in short-term highly liquid investments. These funds are designed to offer a competitive yield, liquidity, and minimal risk. Unlike high yield savings accounts, these funds are not FDIC insured and do carry market risk where the amount invested has the potential to decline.
Conclusion
An emergency fund is a foundational piece of a strong financial plan. Having cash set aside will allow you to pay for unexpected expenses and keep working towards your financial goals. It is important to remember that wherever you decide to keep cash for emergencies, the money will be available when you need it. If you don’t have an emergency fund, consider developing a plan to build one this year.
- Bankrate – “Survey: Less than half of Americans have savings to cover a $1,000 surprise expense”