Once you’ve built a budget and started getting some extra monthly cashflow, you’ll want to establish an emergency fund. An emergency fund is exactly what it sounds like—it’s there for emergencies only. As such it should be put away in a savings account, CD, or money market account and forgotten about. The purpose of an emergency fund is to help you in times of unpredictable circumstances such as a job or car loss. If a home repair or car accident is too small of a cost to claim on insurance, you’ll need to cover the cost out of your savings or monthly cashflow. Common uses of an emergency fund also include replacing a home appliance, paying an unexpected medical bill, or needing to hire an expert for specialized services.
The rule of thumb for your emergency fund depends on your relationship status and your sources of income, but ranges from 3-6 months of living expenses. If you’re single with one income then you need six months of living expenses whereas if you’re married with two sources of income you only need three months of living expenses, because your risk is diversified between the two sources of income. If you’re single with an income from a job and an income from an investment portfolio, disability payment, or somewhere else than you only need a 3-month emergency fund. If you’re married with only one income then you need greater than a six-month emergency fund.
You can invest or place your emergency fund in one of several different places. If you need immediate access to your money, then you can just park it in a savings account. A savings account at your local bank probably returns .10%, but there are incentive plans where bank savings accounts will pay up to 5% if you meet certain qualifications. You can also put your money in a money market account, which will pay more than a savings account and provide the same level of liquidity.
An even more sophisticated approach would be to put your emergency fund in laddered CDs. The acronym “CD” stands for “Certificate of Deposit” and is an savings vehicle at your local bank, online bank, or credit union. Investing in a CD ties up your money for different amounts of time for guaranteed rates of interest. You can invest in a CD for 2-60 months at a time. A laddered CD approach would be to invest in CDs with different maturities, so that your CDs are regularly maturing. If you need some of your money, you can get to it without having to pay early withdrawal fees.
For an example, say you had an emergency fund of $25,000. You could invest $5,000 into CDs maturing in 1,2,3,4, and 5 years. In one year’s time your first CD will mature and you’ll reinvest that into a 5-year CD so now you’re back where you started. Say a year later you need $5,000. You simply take that out of your CD which matured and is now worth $5,203.88 (assuming a 2% annual rate, compounding monthly for 2 years). Now you still have the other 4 CDs sitting in there making you money passively and they are still fairly liquid. Generally you’ll be charged 3 months worth of interest if you take money out of a CD prematurely which isn’t a terrible price to pay, but can be avoided with some planning.
The most important thing concerning your emergency fund is to just make sure that you establish one and that you treat it as a genuine emergency fund without tapping it for monthly cashflow needs. As your emergency fund grows and reaches a good level equal to 3-6 months of living expenses you can move on to the next step on your financial journey, which is paying down debt.