An emergency fund represents the foundation of your financial fortress. You’d be hard-pressed to find a single financial advisor, book, or podcast that advises against creating one. When it comes to deciding where to store an emergency fund, however, controversy abounds. Let’s break down your options.
Introduction to Emergency Funds
Conventional personal finance wisdom tells us to build an emergency fund that will cover three to six months of living expenses. And no doubt, this is sound advice.
Socking away this money is a huge early financial milestone for many young professionals. It builds confidence, peace of mind, and financial resiliency. It’s an early win that creates momentum towards even bigger and better financial victories. You should aim to achieve this goal ASAP if you hope to build bulletproof wealth in your 20s.
So this is all well and good. But it’s a concept that’s been beaten to death by every financial pundit, blogger, podcaster, Instagrammer, and TikToker out there. We get it, saving more money is ideal.
Tactical Considerations
I want to focus on a more nuanced aspect of the emergency fund here. It’s a piece that often goes overlooked and undiscussed.
Where, specifically, should an emergency fund be saved and stored?
To answer this, let’s consider the fundamental purpose of an emergency fund. The goal is to provide short-term liquidity during times of personal crisis. It’s financial hedge against whatever future tragedies and calamities await us in life. This may sound grim, but it’s prudent to approach personal finance with an eye towards the worst possible outcome.
To fulfill its purpose, then, the emergency fund must be stored somewhere that’s relatively “liquid.” This means that it’s easily accessible. Ideally, the emergency fund should also be stored somewhere safe, perhaps with the added benefit of insurance protection.
Most would agree on the above points. Here’s where opinions start to differ.
Some savers also prefer to seek greater financial returns on their emergency funds. I sympathize with this aspiration. After all, inflation eats away at the value of cash by the second! But a constant tension exists here. An asset’s expected return directly correlates with the risk it presents.
In the hopes of achieving greater returns, a saver must expose these funds to more volatility. And remember, the explicit goal of this emergency fund is to hedge against the inevitable disasters that will confront us at some point in life. It’s a risk mitigation tool.
This post examines the six primary ways that an emergency fund can be stored. It’s helpful to frame the discussion by plotting each of these options on a scatterplot showing relative liquidity and expected return. Keep in mind, expected return is synonymous with risk. Take a peek at the diagram below, then dive into the details around each option.
The Emergency Fund Opportunity Spectrum
The All-Cash Emergency Fund
In some instances, cash is certainly king. This is not one of those instances.
As mentioned above, cash held outside of an interest-bearing account loses value by the second. Think of inflation as an unrelenting wild fire burning your paper bills by the year. It destroys the purchasing power of today’s dollar over time.
The all-cash emergency fund does boast the highest level of liquidity. You could theoretically reach under your mattress and use cash instantly.
But it offers an impractical solution to the emergency fund conundrum. The all-cash fund offers limited security and peace of mind. It doesn’t carry insurance protection, and cash yields a negative inflation-adjusted return.
You can, and will, do better.
The Checking Account Emergency Fund
A checking account provides the next best level of liquidity. Savers can access funds using an ATM, debit card, or written check. Sure, the money might not sit within physical reach like the all-cash emergency fund, but the checking account allows withdrawals almost as seamlessly.
At one point in time, banks offered decent interest rates on these accounts. Those days are long gone. These days, checking accounts provide paltry returns that barely outpace mattress cash. You’re not quite lighting your money on fire in a checking account, like you are by holding physical cash, but it’s close.
On the positive side, checking accounts at reputable banking institutions carry FDIC insurance. This means that your funds are protected (up to $250K) by the federal government in the event that a bank defaults. This added protection fosters enhanced peace of mind.
While perhaps not the optimal choice, the checking account emergency fund provides almost the same level of liquidity as mattress cash with the added benefit of FDIC protection.
The Money Market Emergency Fund
A money market account offers moderate liquidity and interest rates. Similar to a checking account, savers can write checks and use debit cards to access their funds. They also carry FDIC insurance. But money market accounts bring some additional restrictions that serve to reduce their liquidity.
For instance, accountholders often face transaction limits and account minimums. If a saver’s balance dips below pre-established thresholds, banks may levy fees or even close accounts altogether. Additionally, money market interest rates are often tiered by account balance such that larger total balances garner increased interest rates. This means accountholders may be forced to tie up large sums of cash to enjoy a money market fund’s full benefits.
The High Yield Savings Emergency Fund
A close cousin of the money market account has emerged with the advent of online-only banking. Examples include Marcus by Goldman Sachs, CIT Bank, and Ally Bank.
These banks operate with limited or non-existent branch locations, drastically reducing overhead costs. They pass some of these savings along to consumers in the form of higher interest rates and lower fees with their high yield savings accounts.
These types of accounts aim to offer respectable interest rates and liquidity. Once again, they are FDIC-insured as well. In comparison to money market accounts, they may offer slightly better interest rates. But this varies by year and bank. The rates tend to be close enough that the difference in return is marginal.
High yield savings accounts are also a bit less liquid than money market accounts. Users cannot typically use an ATM or debit card to access high yield savings funds. Instead, they must initiate an online transfer to another account (such as a checking account) that allows them to access the money. This is by no means an arduous process. But the transfer creates an added hurdle and potential time lag for accountholders who need immediate access to emergency funds.
Savers must weigh the benefits of increased yield versus the somewhat diminished liquidity that these savings accounts provide. After all, there’s no free lunch in banking.
The Certificate of Deposit Emergency Fund
A Certificate of Deposit (CD) represents one of the most illiquid ways to hold an emergency fund, but it tends to offer higher returns. CDs are also covered by FDIC insurance.
With a CD, savers commit to leaving a sum of money deposited in a bank for a set length of time in exchange for interest payments. Think of it like providing a loan to the bank.
A CD’s term could range from a single month to five or ten years. Generally, the longer you park money in the CD, the higher the interest rate you’ll be given. While depositors can withdraw funds prior to a CD’s expiration, a penalty will be charged.
This poses a challenge for those hoping to maximize yield while using a CD emergency fund. Savers must walk a precarious tightrope between juicing yield and maintaining adequate liquidity to fund an unexpected catastrophe. This essentially requires a roll of the dice that disaster won’t strike for the duration of a CD’s term. While it’s reassuring to know that you can withdraw the funds prematurely if needed, the time restrictions presented by a CD defeat the purpose of an emergency fund to some extent.
To mitigate this liquidity issue, some people opt to create a CD ladder. This involves stacking CDs on top of each other at progressively longer terms to stabilize cashflow while preserving some liquidity.
The Invested Emergency Fund
This is the most aggressive, highest yield emergency fund strategy. Some savers choose to invest an emergency fund in the market using a Roth IRA or taxable brokerage account. No FDIC insurance is provided on these accounts.
On the one hand, even the highest yield savings and money market accounts won’t keep pace with inflation rates in our current economic environment. Investing an emergency fund in equity indexes provides an opportunity not just to keep pace with inflation but to significantly outpace it.
Of course, this opportunity comes with much greater risk. Although investors can liquidate positions in taxable brokerages and withdraw Roth IRA contributions (gains cannot be withdrawn penalty-free) at anytime during market hours, it’s not quite so simple.
See, when you invest an emergency fund, you might be forced to sell at exactly the wrong moment. The nature of an “emergency” is often sudden and devastating. You won’t be able to predict it. You can’t reallocate funds to optimize for the instant your emergency will occur.
Additionally, personal life crises are often correlated with broader market dynamics. For example, you may lose your job during the midst of a recession. This presents a worst-case scenario, forcing you to liquidate assets at their least valuable point and lock in these losses. In a particularly dire situation, the assets might not even hold enough value to cover your emergency.
There are some compelling arguments out there in favor of the invested emergency fund. If you choose to employ this strategy, be sure to perform adequate research and consider hedging your downside by adding fixed-income assets into your emergency fund portfolio.
The Perfect Strategy?
We’ll all face various tragedies throughout our lives. We can choose to dismiss this fact. Or we can choose to embrace it by building financial resiliency.
An emergency fund is a foundational piece of a healthy financial life. But there is no single right way to structure one. It depends on factors such as your age, risk tolerance, and personality type. As with most aspects of personal finance, this decision is incredibly individual.
I personally fall somewhere in the moderate camp. I’m not sleeping with cash under my mattress, but I also don’t feel the need to pursue an overly aggressive emergency fund strategy. I’ve used both money market and savings accounts throughout my life.
In my mind, investing in the market or CDs defeats the core purpose of an emergency fund. I prefer the peace of mind that a more liquid cash position provides over the potential returns I could chase with these alternate methods.
And there’s one additional reason I avoid investing my emergency fund. It goes back to my investing mindset. At this point in my life, I’ve committed to being an unwavering accumulator of assets. I want to avoid falling into the habit of selling assets to fund my lifestyle. Even in an emergency scenario.
But this is all just personal opinion and preference. Experiment for yourself. Try spreading your emergency fund over a few of the account options that we discussed.
See what strategy helps you sleep best at night. Just don’t sleep at night…on a large pile of cash…losing value by the second. Please!