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There are a lot of lessons to glean from the recent coronavirus pandemic. One is that you never know when an emergency can strike or how long it will last. Life for everyone changed starting in the early months of 2020.
Nearly 20 percent of American households lost all their savings during the pandemic. That number increases to roughly a third for all households making $55,000 or less annually. As devastating as that may have been for these families, it could have been much worse if they didn’t have an emergency fund to rely on.
What is an emergency fund?
An emergency fund is what it sounds like: money set aside to help cover potential emergencies. Typically, these emergencies involve unforeseen medical expenses, a loss of income, or significant home and vehicle repairs. The goal is to use your emergency fund instead of depending on credit cards or personal loans that usually come with high-interest rates.
The key to having an emergency fund is that the assets inside should be highly liquid. Ideally, your emergency fund should be as close to cash as possible.
Stock options, retirement funds, and collections are not good examples of emergency funds. You need to access your emergency funds very quickly, and cash is the best way to do that.
How much do I need in my emergency fund?
How much money you stash in your emergency fund will vary significantly from person to person. The amount of money you earn, your lifestyle, the number of dependents you have, and your monthly expenses will determine how much you need to save.
Your personal finances—including retirement savings goals, current financial security, and long-term financial goals—also come into play.
As a rule of thumb, you should try to save a safety net of between three to six months of living expenses. This way, unexpected expenses won’t ruin your financial plans or put you in a challenging financial situation. Some of these unplanned expenses include:
- Home repairs
- Car repairs
- Job Loss
- Medical Bills
Additionally, these unexpected events can put you behind on regular payments for your mortgage, utilities, or student loans. While you may have peace of mind about your current financial well-being, your direct deposits won’t automatically rise to meet your needs in the event of a costly unplanned event.
It can take a while to slowly build your emergency fund if you’re starting from scratch. Three to six months of expenses can easily equal several thousand dollars.
The critical thing to remember is that every little bit helps. As long as you’re slowly adding to your emergency fund every week or two, you’ll be able to reach your target eventually.
Where should I keep my emergency fund?
Creating an emergency fund is a tricky balancing act. On one hand, you want to ensure that you have enough liquid assets to cover an emergency. On the other hand, you don’t want to overload your emergency savings as you can miss out on some crucial financial benefits.
For example, the average annual return for an Individual Retirement Account (IRA) is usually between 7 percent and 10 percent. Return rates that high make IRAs one of the best savings options available. However, the money isn’t liquid, and you can’t access it without incurring a penalty, so it doesn’t make for a good emergency fund.
Here is a list of the best places that you should store your emergency fund:
There’s nothing more liquid than cash, so you can access your emergency fund the fastest when it’s in this form. The biggest issue with keeping a large sum of money in cash is that it is relatively risky.
Cash can be lost, stolen, or damaged, so you must keep it safe. Using a personal safe or a safe deposit box are two options, but both will cost you.
Another issue is that cash doesn’t grow. Whatever amount you put into your emergency fund is the exact amount you’ll have tomorrow, next week, and next year.
Alternative options allow your money to grow while being better protected. There’s nothing wrong with keeping some cash on hand, but it probably shouldn’t be the entirety of your emergency fund.
Traditional Savings Account
The majority of Americans have checking and savings accounts with financial institutions. Stashing your emergency fund in your savings account is very convenient. Most institutions will allow you to withdraw directly from your savings accounts or transfer it to checking, where it can be removed.
The main issue with traditional savings accounts is that the interest rate is virtually nonexistent. You’ll likely only be earning a few pennies in interest each month. While that’s technically a little better than cash, it’s not enough to make any noticeable difference over time.
You’ll also need to be aware of the maintenance fees charged by banks. Typically, these fees are easily waived as long as you meet a few qualifying criteria. In most cases, maintaining a certain balance or making a predetermined amount of transfers is all it will take to avoid these fees.
Money Market Account
Most traditional banks and credit unions offer customers the option to open money market accounts. It’s easiest to think of these accounts as a fusion of conventional checking and savings accounts. You’ll have the interest-bearing properties of a savings account but can write checks or withdraw like a checking account.
The best reason to look into a money market account is that the interest rate is usually higher than what is offered to standard savings accounts. It’s not enough to make a huge difference, but there’s no reason to turn down free money. It can also make it easier to leave your emergency fund alone if it’s separated from your primary checking and savings accounts.
The only downside of a money market account is that the requirements are usually more strict than a regular savings account. You’ll probably need to make a higher initial deposit to open it and maintain a higher monthly balance to avoid monthly fees. Ensure that you can quickly meet these requirements before opening your account.
High Yield Savings Account
The evolution of technology has provided more savings options than there used to be. Instead of being limited to physical banks and credit unions, you now have the opportunity to utilize online-only options.
Online banks generally offer higher interest rates on their accounts than traditional options. There are no physical branches to protect and fewer employees to pay, so the savings get passed to you. The interest rates aren’t going to be nearly as high as long-term savings options. However, you should expect to receive interest that’s well higher than the rate offered by your current bank.
The only downside of using an online-only bank is that you might have trouble accessing your money. Most of them use specific ATMs and will charge a fee for using one that’s out of network. Also, most online banks limit the amount you can withdraw in a single day. Having several thousand dollars saved is excellent, but not if you can only access $300 at a time.
Certificate of Deposit
A certificate of deposit (CD) is a short-term investment option available at most banks and credit unions. The best part about using a CD for your emergency fund is that you’ll probably be given a much higher interest rate than any other option on this list. However, the elevated interest rate is the downside of losing your liquidity.
CDs are timed investments spanning a few months or a few years. You’ll deposit the money and can only access it when the predetermined deadline is met. Technically, you’ll be able to access the money earlier if you want. However, various penalty fees will be charged to eliminate the interest you earned and cost you some money.
Using a CD to store your emergency fund is a higher risk than the other options due to the limited access to your money, but also includes higher rewards. You should probably avoid putting all your emergency funds into a CD, just in case. Also, it would be a good idea to limit the length of your CD to less than a year to keep your options open.
Using a prepaid card is an option that’s a little different than the others on this list. You would load money onto the card periodically and only be able to spend the amount on it. A prepaid card is like turning a bundle of cash into a single piece of plastic. It will be much easier to handle than cash, but several potential downsides remain.
The main issue is that prepaid cards aren’t usually connected to financial intuitions. It can be tricky when you’re trying to add more money.
You’ll also have to pay a fee to purchase the card, and you might be charged whenever you add money. No interest rate is attached to a prepaid card, so your money won’t grow and can be lost, damaged, or stolen.
It might be a good idea to stash some money on a prepaid card in case of an emergency, but not all of your funds. There are too many potential downsides with a prepaid card, so you should limit it to $100 or less.
Start an emergency fund today to prepare for the worst
Just like unexpected windfalls, a financial emergency can strike anytime. You must be prepared for the worst. The best time to prepare for a rainy day is when the skies are blue. If you’re currently able to save money, you should create an emergency fund just in case. An emergency fund can prevent a financial setback from becoming a catastrophe.
There are several different places where you can stash your emergency fund. Each of them will come with unique benefits and drawbacks. You’ll need to decide which one is the best fit for you. You should aim for the highest-interest option while keeping your money liquid. You might not need your emergency fund for a while, so wasting its potential for further growth would be a shame.
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