Hey there! If you’re trying to figure out what the right account to use for your emergency fund is, you’ve come to the right place! By the end of this post, you will have a clearer idea of how much you should save and where to actually put your emergency fund.
If you’re still not quite convinced that you should have an emergency fund at all – or are wondering if you need the one you have – head over to my post on Why You Should Have An Emergency Fund. The answer may surprise you!
And before you dive into all the content below, know that I’m firmly in the “do what works best for you” school of thought. Yes, there are a TON of ideas below. But please take what works and leave the rest. And remember, I’m no financial expert! Just someone who wants to help you build net worth in a friendly and supportive way.
With that out of the way, let’s dive in.
How Much To Have In Your Emergency Fund
If you are living paycheck to paycheck, I agree with the Dave Ramsey advice to try your hardest to save up $1000 first. Drop all other priorities and put every penny you can toward $1000.
If you have more room in your cash flow, I challenge you to build up to at least 4 months of living expenses. And if you crave safety, or have volatile income, shoot for the full 12 months. In fact, many in the financial media space recommend saving up a full 12 months of living expenses amidst all the uncertainty these days.
In Summary: At least $1000, at most 12 months living expenses. Find your happy medium.
Accounts To Use For Your Emergency Fund
The options for what accounts to use for your emergency fund can get a little overwhelming. So my suggestion for you is this: go with whatever account is the balance of what convenience, simplicity, and optimization are for you.
What does that mean? Well, generally speaking, the most convenient and simple options (savings accounts) usually have the lowest returns. But the upside is that there is zero volatility, the money is insured by the FDIC, and you can access your funds immediately (if your checking account is in the same institution).
Meanwhile, optimizing your accounts means finding options that give you a higher return on your money. As far as I know, the only way to do this is to actually invest your money. As you’ll see, the two ways I review are investing in municipal bond funds (what I do) or using the principal of your Roth IRA (highly controversial, but popular enough to explore here).
It’s very important to note that the downside of investing your emergency fund is that your money is not insured or guaranteed to retain its value. That means that you could in fact lose some (or all) of the money you put into the account. However, the returns are much higher than even the highest yield savings account.
Now that you have a better understanding of the foundations of typical emergency fund accounts, let’s dive into the specifics! These are ordered roughly by how risky they are, aka how likely you are to lose your money. Right off the bag, I’d strongly suggest you have at least some money in an FDIC-insured account (first 3 options). After that, it’s up to you!
Traditional Savings Accounts
You probably have one of these, or used to have one before you moved your money somewhere else. These accounts are convenient because if you open one with the bank that holds your checking account, you can have virtually instant access to your savings in a true, immediate emergency (like one where you couldn’t use your credit card and needed cash). They are also usually FDIC-insured, meaning your cash is safe up to $250,000. The downside is that they currently have utterly abysmal interest rates, hovering at 0.05% or less (as of January 2021).
High Yield Savings Accounts
These are very similar to traditional savings accounts, and both online-only and traditional brick and mortar banks carry them. With the latter, however, you may have to maintain a higher balance to get the higher rate. They are also FDIC-insured. The upside is that your rate could be ten times the national average (currently 0.50% as of January 2021). The downside is that transferring money to your checking account – if housed at a different bank – could take 2+ business days.
Certificates of Deposit (CDs)
CDs are money deposits you can’t access for a certain period of time. For example, a 1-year CD locks up your money for 12 months. If you withdraw the money within that time frame, you will pay a penalty (usually a percentage of the interest earned).
However, this inconvenience has two benefits: you will have a higher APY than a traditional savings account, and you’ll think twice about trying to spend your money. CD Laddering (click on link for in depth description) is when you spread out your emergency fund into CDs of different lengths to ensure you’re taking advantage of the higher APY rates of longer CDs, while still being able to access some of your money for emergencies.
Money Market Accounts
MMAs are another type of higher yield FDIC-insured account. These are not to be confused with Money Market Funds, which are a type of investment vehicle and don’t guarantee your money. The yield (or interest made) on MMAs is similar to high yield savings accounts, so much so that you may want to compare rates before you open one.
These accounts have a higher return than savings accounts because banks are legally allowed to invest in certificates of deposit (CDs) (described above), government securities, and commercial paper. The latter are short term (7-270 day) loans to companies to raise funds for short term expenses like payroll or new projects.
Other Types of Accounts
I wrote a long post on why we put part of our emergency fund in a municipal bond index fund, which you should check out here. But here is the definition from that post: A municipal bond is a loan you give to a city government, utility company, or similar institution to fund things like infrastructure projects. In return, they will give you a predetermined number of interest payments for a specific period of time. At the end of that period, you get your original loan amount back – on top of the interest payments they gave you!
And here are the three reasons I give for why we use them:
#1: You can potentially get a much higher interest rate on bonds than “high-yield” savings accounts. For example, the Nuveen Intermediate Duration Municipal Bond Fund has a 1-year return of 3.5% vs Ally Bank’s high-yield savings rate of 0.60%.
#2: The interest earned on most municipal bonds are exempt from federal, state, and local income tax. This is not true for interest earned on savings accounts. This is also not true for all types of bonds, just municipal ones specifically.
#3: They experience very little volatility. This means it’s very unlikely you will lose any money on your investment.
I forgot to mention this in the article, but these index funds (if you find the right one) also have low expense ratios. A low expense ratio is always a must for an investment.
For more, be sure to check out my post dedicated solely to municipal bonds!
Money Market Funds
Money Market Funds have many of the same benefits as municipal bond index funds. They only invest in things that are low risk and have little volatility, such as U.S. Treasury bills and high-quality, state-sponsored securities (aka money for local government projects). Thus, if you have access to low-cost money market funds through either your bank or brokerage firm, you may want to consider this as another way of increasing your returns without taking on too much risk. These funds are also highly liquid, which means you can fairly easy withdraw money at any time if you need it.
The Principal of Your Roth IRA
I might get some heat for including this option, but I’ve seen this enough in the financial blogosphere that I thought it worth including. In case you were unaware, you are allowed to withdraw the principal contributions of your Roth IRA (aka the money you put into it) penalty-free at any time. Thus, some people consider the principal contributions of their Roth IRAs as a sort of last-resort emergency fund. I won’t go into any more depth here, but but be sure to click the link above for an in-depth overview at Investopedia. If you do decide to pursue this route, consider having a portion of your overall emergency fund in a more accessible account like one of the FDIC-insured accounts described above.
What To Do Next
I hope this article gave you the information you need to choose the right account account for your emergency fund. Don’t be afraid to change out of the one you already have, or to split up your money between different accounts. The latter approach can help you keep a portion very easily accessible – like in a savings account – while another portion is earning more interest – like in municipal bonds.
Enjoy optimizing your emergency fund!