Step 3 – Establish an Emergency Fund
Bad things happen to good people. Houses burn down or flood. Large medical bills come out of nowhere. Cars get totaled. People lose their jobs. You need to prepare for these unlikely events by having an emergency fund.
An emergency fund is exactly what it sounds like…a fund for emergencies! In other words, it is not a fund to be used when your X-Box or television breaks unexpectedly. It exists for real emergencies so that you don’t have to borrow money (like using credit cards that charge very high interest rates).
How much money do you need in your emergency fund? In the beginning, it might consist of only a few hundred dollars, but it should gradually build to be 3-6 months of living expenses. (Note that I said “expenses” and not “income.” Hopefully your expenses are less than your income.)
Where do you put this money? It should be invested in something very safe, like a checking, savings, or money market account. These are Federal Deposit Insurance Corporation (FDIC) insured and offer immediate access to your money. The downside is that the interest rate offered by these investments usually does not keep up with inflation, so you lose purchasing power over the long haul.
If you are going to use one of these accounts, you want to get the highest interest rate you can on this money, so check bankrate.com to see which accounts offer the highest interest rate. You’ll probably get the best interest rates at on-line/internet only banks. As I write this, the yield on savings and money market accounts for a deposit as low as $100 ranges from 0.01% to 1.4%.
Another place you can put your emergency money is in money market mutual funds (also called “money funds”). They are safe, allow check writing above certain amounts (commonly $250), and historically have earned between 1-5% in interest (although rates are currently near 1% or less). You have to get these from a mutual fund company. Commonly recommended companies include fidelity.com, schwab.com, tiaa-cref.com, troweprice.com, or vanguard.com (my favorite). Important things to look for are the minimum initial investment, the smallest amount you can write a check for, and the expense ratio, which is the percentage you are paying in fees. (In other words, the lower the expense ratio the better.)
Although their minimum deposits can be a tough hill to climb when you are just getting started, you can’t go wrong by putting your emergency money in a Vanguard money market fund once you can meet the minimum investment.
Of note, if you are a high earner and in a high federal tax bracket, a tax-free money fund will likely have a higher after tax yield than a non-tax exempt money fund. There are also state-specific tax free money funds that are exempt from state taxes. For example, as I write this the 1-year yield on the Vanguard Prime Money Market Fund is 0.78%. For the Vanguard Municipal Money Market, which is exempt from federal taxes, it is 0.61%. If I was in the 28% federal tax bracket, my after-tax yield would be 0.56% (0.78% x 0.72). As you can see, that’s lower than 0.61%, so the Vanguard Municipal Money Market would be the better bet.
If this is confusing to you, the mutual fund companies can usually help you decide which of their products is best for you.
Is There Another Way? The Aggressive Approach
What I described above is the conservative approach. The aggressive approach is to keep a smaller amount in reserve, 1-3 months of living expenses for example, and invest it more aggressively. You could keep 1/3rd of it in a money market fund, but the other 2/3rds could be invested in a stock or bond mutual fund/exchanged traded fund (ETF) or some combination of the two that will yield a higher return. This will allow your emergency fund to grow as your income grows, possibly reaching the recommended 6 months of living expenses or more.
If you need more cash than what is in your emergency fund and you have equity in your home, you can usually borrow the money by using a home equity loan, for example, or a credit card. Credit cards have higher interest rates, but this is an aggressive approach and you probably won’t have to borrow any money at all because emergencies are rare.
What Should You Actually Do?
Only you can decide what is right for you. For example, in the military I have full medical insurance through TRICARE and as much job security as anyone can have. I’m not getting fired (or at least I don’t think I am). As a result, my emergency fund usually resides in the low end of the 3-6 month range, as there are very few emergencies I expect to have to deal with. On the other hand, if I had a job I could lose and had to provide my own health insurance, I’d probably have a goal of having 6 months of living expenses (and maybe more) providing a more substantial cushion.
Whether you take a conservative or aggressive approach or somewhere in between, what is clear beyond a doubt is that you and your significant others need to come up with a plan for emergencies that makes sense for you and allows you to sleep at night. If you or your spouse/partner could lose their job, you need to keep enough of a reserve on hand to cover your expenses while you/they secure other employment.
Now for Step 4 – Managing Debt…