4 Steps to Setting Up an Emergency Fund

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A few years ago, I met a lovely couple in their early 50s who were struggling with more than $20,000 in credit card debt. When I visited them at their home in a Chicago suburb, it was obvious that they weren’t profligate spenders; their home was modest, and they said that they hadn’t taken a real vacation in years.

Rather, their credit card problems began once their children started college. Although they were able to cover the tuition costs and typical monthly living expenses with their salaries, their monthly outlay on those two expense categories left no room for error. As a result, they began charging unexpected expenses like car repairs and veterinary care on their cards, incurring exorbitant interest fees along the way.

They were clearly troubled about having dug themselves into such a deep hole, and they were eager to do everything that they could to pay off the debt as soon as possible. We discussed various ideas for reducing their financing costs, such as transferring the debt to a home equity line of credit or borrowing from one of their 401(k) plans, both of which are preferable to high-interest credit card debt.

What I think surprised them, though, was that I didn’t suggest that they put every extra penny toward paying down their debt. Rather, I urged them to simultaneously set up an emergency savings fund. True, setting up an emergency fund would probably mean that it would take them longer to pay off all of their debt, but it would also guard against the prospect of taking on any more debt than they already had. Not only could they use their emergency fund to pay unexpected bills, but it would also provide a needed cushion should one of them lose their job.

In fact, creating a safety net in case of job loss is the key reason to set up an emergency fund. Conventional financial planning wisdom holds that you should have three to six months’ worth of household living expenses tucked away in your emergency fund, with the thought being that it would take you that long to find a new job if you should lose yours. However, I would recommend building yourself an even more generous cushion if you can swing it, preferably nine months’ to a year’s worth of living expenses. That’s particularly true if you’re highly paid or work in a highly specialized field, because it’s usually more difficult to replace such jobs. And of course, if you have any reason to believe that your job is in jeopardy—either because of problems in the economy at large or at your own company—you should also aim to build a larger emergency fund.

In addition to determining the right amount for your emergency fund, you also have to take care in selecting the investments that you put inside it. As a general rule of thumb, your emergency fund should consist of investments with maturities of less than one year, including checking and savings accounts, money market accounts, and CDs. This is money that you could need to tap in a pinch, so you want to steer clear of higher-yielding investments that could be tough to sell or that you might have to sell at a loss if you needed to get out in a hurry. Instead, you need to stick with vehicles that ensure you’ll be able to take out as much as you put in.

Here’s an overview of the types of savings and investment vehicles that are acceptable for your emergency fund:

• Online savings accounts: These vehicles currently offer the most attractive yields for cash--as much as 1% or even higher in some cases. They also typically offer at least a few transactions per month. Deposits of up to $250,000 per institution will be covered by FDIC insurance.
• Checking and savings accounts: Convenience is the big plus here, but rates may be rock-bottom. Deposits of up to $250,000 per institution will be covered by FDIC insurance.
• Money market deposit accounts: These interest-bearing savings accounts typically offer a limited number of transactions per month, and deposits of as much as $250,000 per institution are FDIC-insured.
• Certificates of deposit: CDs are apt to have a higher yield than checking, savings, or money market accounts. They also carry FDIC insurance for deposits of as much as $250,000 per institution. The big drawback to holding CDs in your emergency fund, however, is that you'll pay a penalty to withdraw money from a CD prematurely. So if you hold CDs as part of your emergency fund, you'll have to weigh the higher yield against the risk of having to pay a penalty to pull money out.
• Money market funds: A money market mutual fund can be a good option for an emergency fund, and yields may be higher than what you'd earn on your checking, savings, or money market account. Because money funds buy very short-term bonds, they can readily swap into newer, higher-yielding securities when interest rates edge up. The big downside relative to the checking and savings accounts, CDs, and money market accounts is that money market fund assets are not FDIC-insured.

If you opt for a money market fund, low costs should be your key consideration. That’s because the amount that you pay in expenses will be the key determinant of the yield that you get to pocket. (Expenses are deducted directly from yield.) You should pay no more—and preferably much less—than 0.50% in expenses for your money market fund. One other tip: If you do spy a fund with very low fees, make sure that the fund company isn’t temporarily waiving part of its expenses in an effort to attract new investors. Such waivers can readily be reversed. Also be wary of a fund with a yield that’s substantially higher than that of the competition, especially if the fund doesn’t have very low fees. It could be investing in lower-quality securities to pump up its yield and pumping up its risk level at the same time.

Also bear in mind your tax bracket when shopping for a money fund for your taxable account. Even if you’re not in the highest tax bracket, it may make sense to opt for a tax-free money market fund over a taxable one. That’s because the muni fund’s yield may actually be higher than the taxable fund’s once you factor in taxes.

Here are the key steps to take when setting up your emergency fund.

Step 1: Determine your monthly living expenses. Don’t include nonessential items that you could live without in a pinch, such as housecleaning and discretionary clothing purchases. Multiply that number by three months. This is your absolute minimum savings target for your emergency fund.

Step 2: Add up the aggregate investments that you hold in your checking and savings accounts, money market accounts and funds, and CDs. Exclude any assets that you have earmarked for other purposes, such as money that you’re saving for a car down payment or college tuition; also exclude any cash holdings in your stock or bond mutual funds. This is your current emergency fund.

Step 3: Subtract the figure from Step 2 (your current emergency fund) from the figure in Step 1 (your target emergency fund). This is how much you need to save at a bare minimum—it should be double this level or more. Setting money aside to hit this savings target should be your main savings priority in the months ahead. (If you’re also paying off high-interest credit card debt, you should try to build up your emergency fund at the same time.)

Step 4: To home in on the best investments for your emergency fund, start by looking at the yields for your current investments. Then go to www.bankrate.com to find current yields for CDs, money market deposit accounts, and money market mutual funds; compare them with what you're earning currently. Bearing in mind the above guidelines about FDIC insurance and liquidity, also remember that it's fine to use a combination of these vehicles rather than holding your entire emergency fund in one place. For example, you may choose to keep two months' worth of living expenses in your checking account and the rest of your emergency fund in a higher-yielding CD or money market fund.

Next Steps

• If you're a homeowner, it can make sense to augment (but not replace) your emergency fund by setting up a home equity line of credit to use in case of emergency. That way, should you find yourself in a real bind and have to exhaust your emergency fund, you'll have another safety net in place. Interest rates on HELOCs are usually quite low relative to other forms of financing, and the interest is tax-deductible in most situations. Set up a HELOC while you're employed, because it's much harder to secure this type of financing if you're not.
• Although it's not ideal to use your retirement savings as a piggy bank, your Roth IRA can help back up your emergency fund if need be. You can tap Roth IRA contributions at any time and for any reason; because of that flexibility, setting one up is a great first step when you get started in investing.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar, Inc.