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The conventional wisdom is that everyone should have three-to-six months’ worth of expenses in an emergency fund, but nowhere in that rule of thumb is it made clear where this amount of money should be stashed. And having your emergency fund in the wrong place can cost you.
Here’s what you need to know about where you should be stashing your rainy day money:
Cash Savings at Home
Anyone who has lived through a major natural disaster understands why there’s an excellent reason for keeping some actual cash in your home. Having cash available to purchase food, water, and supplies in the event that power is out and you can’t use debit or credit cards is an important part of disaster preparedness.
But even without a large-scale disaster that affects your entire area, you may face some sort of personal emergency that would make it impossible to use your credit or debit cards.
Of course, there’s a reason why “keeping money under your mattress” is short-hand for poor financial management. It may be smart to have some cash available at home in case of emergency, but that should hardly be the only place you stash emergency money.
Not only is cash vulnerable to theft, but any money you have lying around in literal cash is also losing value to inflation. Instead of earning you interest, cash at home is actually being eaten away by inflation.
How Much Should You Keep at Home in Cash?
Considering how vulnerable cash is to both theft and inflation, it’s a good idea to keep no more than $100 to $200 in cash at home. That amount should be sufficient to get you through the worst parts of an emergency without tying up too much of your emergency fund in a vulnerable spot.
As for where you should keep your cash emergency fund, plan on getting a safe to use at home. Fireproof and waterproof safes that are either too heavy to carry or bolted in place are an excellent spot to stash not only your cash but also your important documents.
What About Your Checking Account?
Keeping a cushion of extra money in your checking account can be a savvy financial move to ensure that you never overdraw your account. Having that extra money can also provide you with peace of mind in case of an emergency since you know you have money available that is not already earmarked for outgoing bills or other payments. In addition, checking accounts (along with savings accounts, money market deposit accounts, and CDs) are FDIC insured up to $250,000–which means your money is safe even in the event of a bank failure.
There are a number of problems with keeping a big chunk of your emergency fund in your checking account, however. First, the majority of checking accounts offer no interest whatsoever, which means any money left in there is losing value to inflation, just like your cash at home.
Ease of access is also a potential problem with keeping emergency funds in checking. It can be difficult for many account holders to maintain the emergency cushion in their checking account without accidentally spending it.
How Much Should You Set Aside in Your Checking Account?
If you keep careful track of your finances, then you can afford to have a smaller buffer–between $250 and $1,000. If you do not necessarily track every penny, you may want to keep a larger cushion–anywhere from $1,500 to up to an entire month’s worth of take-home pay.
Just remember that every extra dollar you keep in your checking account is losing value to inflation. This can help motivate you to track your money more carefully so you don’t need quite as large a buffer in checking.
Okay, What About Your Savings Account(s)?
Savings accounts are the most common place to set aside money for an emergency fund. Not only do you earn a little interest on your money in a savings account, but savings accounts are also FDIC insured.
In addition, putting your emergency fund in a savings account keeps it out of sight, which means you are much less likely to spend it accidentally. But savings accounts are also relatively easy to access in the event of an emergency, which means they offer the best combination of security (from both your spending temptations and theft) and access. However, the interest on savings accounts can vary, and none are currently very high. In some cases, the interest rate is so low that it doesn’t offset inflation–which means that savings accounts are not the end-all, be-all of emergency fund placement.
There are a number of different ways to put your emergency funds into a savings account, each with their own pros and cons:
- Brick and mortar savings accounts: Every traditional bank and credit union offers some sort of savings account to customers. These accounts are convenient for current banking customers, and it is very easy to access your money from them. You can often withdraw funds from such savings accounts via your bank’s ATM, and you can generally transfer money to your checking account instantly. The downside of these types of accounts is their low-interest rates and potential fees. Most brick and mortar savings accounts offer the lowest rates of any type of savings accounts and traditional accounts are most likely to charge fees, making this a poor choice for stashing a large chunk of emergency savings.
- Online savings accounts: Because online banks do not have to maintain physical branches, they have lower overhead than their traditional counterparts–and that savings shows up in their higher interest rates and lower fees. Your money can grow more quickly with online savings accounts, and you are generally not subject to as many (or as hefty) fees that you might find with a traditional savings account. The only caveat is that it can take up to three business days to access money from an online savings account, which means you cannot count on these funds in the case of a sudden emergency. However, if you are able to pay for such an emergency with a credit card, you can use money from your online savings account to pay it off.
- Money market account: Money market accounts (MMAs) are a savings product that double as a checking account, with an interest rate that is much more generous compared to that of traditional savings accounts. You can find MMAs at both traditional banks and online banks, and you can shop around to find the best rate available–although the higher rates are often tied to MMAs with high minimum balances. Because these accounts work a little like checking accounts, your money is easily accessible in case of an emergency while still earning you a relatively high-yield.
- FinTech apps: Savings and investing apps can offer you a fully 21st-century method of amassing an emergency fund. The options run the gamut from automatic savings to automatic investing to behavioral change, and the benefits and drawbacks for each specific app also vary widely. In general, apps are the best option for any saver who wants to productively ignore her money while it grows. There are often more lucrative options for anyone who is more hands-on with their money.
How Much Should You Set Aside in Your Savings Account(s)?
Even the best high-yield money market accounts currently offer an annual interest rate of 2% or less. Inflation is currently 1.9%, which means your money is only truly earning 0.1% per year–provided you actually find an account with a 2% interest rate.
And the national average savings account rate is as low as 0.06%–which means inflation will eat 1.84% of your emergency fund with every year that passes. Since inflation, like interest, compounds, your money will lose value over time. For example, if you have $10,000 in a savings account with a 0.06% interest rate and 2% inflation, your money will only be worth approximately $6,811 of today’s dollars in twenty years. (If you would like to check my math, this is the inflation calculator I used.)
So how much is the right amount of money to keep in a savings account? It’s important to keep some cash in a savings account (or money market account, or saved via an app) so that you can access the money quickly, just in case. But above a certain emergency fund threshold, you’ll find that your emergency fund is collecting dust (and losing value) in a savings account when it could be working for you.
That threshold will depend on the saver. Some people feel anxious without a fat savings account in case of emergency, and it is reasonable to work within your money psychology–provided you have a handle on retirement savings and other investment accounts.
If you are following the rule of thumb that you need three-to-six months’ worth of expenses set aside for an emergency, then having one-to-two months’ worth of expenses in a savings account can provide you with the funds you need without damaging your ability to let your money grow.
If you have successfully put aside three-to-six months’ worth of expenses, then you’re probably looking at a too robust cash cache, checking account, or savings account. Having that large of an emergency fund in anything other than an investment means that your money is losing value. If you invest it wisely, however, your emergency fund can grow through the magical power of compound interest, making it worth far more than what you initially set aside.
On the other hand, investing your money also exposes it to the volatility of the market, which means it could potentially lose value dramatically during a market downturn. In addition, any money that you have invested will often be difficult to access quickly or without penalty.
How Much Should You Invest?
If you have cash at home, a cushion of money in your checking account, and up to two months’ worth of expenses set aside in your savings account, then you are in a great position to invest the rest of your three-to-six-month emergency fund. Since you will have enough cash on hand via your home safe, your checking account, and your savings account to get you through up to two or three months’ worth of expenses, you have the time to allow the remaining invested money to overcome any temporary dips in the market if you need to keep accessing your emergency fund.
How Much to Set Aside and When
It can be tough to know where to start building your emergency fund, so here are some good rules of thumb for getting to a fully-funded emergency fund:
- Create a Plan B budget. The primary reason for setting aside several months’ worth of expenses is to protect yourself against a job loss. But you can also protect yourself by figuring out what you can cut from your monthly expenses in case of a financial emergency or downturn. This can help you weather a job loss with a smaller emergency fund if you haven’t fully funded yours when the excrement hits the fan.
- Make contributions to your emergency fund a consistent line item in your budget. It’s easy to think of saving up for an emergency fund as a once-and-done activity, but it should be a consistent part of your budget. You should also plan on adjusting the amount you set aside in your emergency fund as your income and expenses grow and change.
- Rebalance regularly. If you are consistently sending money to your emergency fund, then you will regularly see your low-interest accounts grow bigger than you need them to be. Make sure you move money from savings to investing whenever your emergency fund outgrows your threshold.
How Do You Know if You’re on Track?
By age 25, you should have at least $1,000 set aside in a savings account, plus a small cushion in your checking account. In addition, you should be setting aside money for retirement–at least enough to receive your company match.
By age 30, you should have at least a month’s worth of expenses saved in a savings account, a cushion in your checking account, and some money invested. You should also aim to have at least one year’s salary saved for retirement.
By age 35, you should have a fully funded emergency fund, including some cash on hand at home, a cushion in your checking account, up to two months’ worth of expenses in a savings account, and two to four months’ worth of expenses invested. You should also aim to have about two years’ salary saved for retirement.
By age 40, you should have a fully funded emergency fund (including all of the above), as well as more than four months’ worth of expenses invested. You should also aim to have about three times your annual salary saved for retirement.