You want it easily accessible, but not readily accessible. If the emergency fund is in your checking account, you can walk to the ATM and pull it out. To me, that defeats the purpose. —Jacob Sybrowsky
What's it going to be this time? Will the transmission on the Audi go out? Will the company downsize? Will somebody have an accident or a rare disease?
For Miranda Marquit, a freelance journalist in Logan, Utah, it was a basement flood.
These are the unexpected shocks that can devastate income, cash flow and credit scores. And they can happen to anybody in the months and years ahead.
They could happen tomorrow. They may even happen on the way home from work. This is why financial planners, gurus and experts all advise having some sort of emergency fund — money set aside to smooth out the financial bumps that can't be anticipated. But knowing how much is enough to offset the unanticipated and knowing where to keep that money are open for some debate. A study recently published in the Journal of Financial Planning, "Is an all cash emergency fund strategy appropriate for all investors?" has found some new twists that challenge some previous assumptions.
Leanne Kramer, a certified financial planner and certified investment management analyst in Olympia, Wash., says emergency funds are the way to buy time to find a job when you lose your job. "Hot water heater go kaput the same time your car needs a new head gasket?" she says. "Emergency savings will help you there. It is specifically for the unexpected emergencies that come up. And they do come up."
Kramer also says emergency funds can break the cycle of credit card debt. "If you have a cushion," she says, "you won't need to use a card to pay for the unexpected."
The standard advice for emergency funds is for people to have three to six months' worth of expenses set aside in an easy-to-access fund, such as cash in a savings or checking account. Some experts, such as Kevin Gallegos, vice president of Phoenix, Ariz. operations for Freedom Financial Network, bump it up to six to nine months of living expenses. "While that may sound daunting," Gallegos says, "it is an attainable goal, even in challenging economic circumstances. The key is to start with what's 'just enough.'"
Jacob Sybrowsky, a co-author of the study on emergency fund strategy, says, however, that even though the standard advice of three to six months' expenses isn't based on real science, it is still probably good advice. "I don't want to fight against it for the average family," says Sybrowski, an assistant professor of personal financial planning at Utah Valley University in Orem, Utah. "We definitely advocate a proper emergency fund. But with a little more detail, we can do a lot more."
Part of that detail deals with how much to set aside. Another part looks at where that money should be kept.
How much to set aside
Gallegos says the amount of money to start an emergency fund can be small. "Think about the level of expense that causes you to rush to a credit card," he says. "That is the amount to start with. Have at least that available, and build gradually toward six or more months' living expenses."
Sybrowsky says although an emergency fund may have many uses (such as Marquit's basement flood) some say its primary use is in case of job loss. He says to look at expenses and income and figure out what income needs to be replaced in case of sudden unemployment. Some expenses may drop right away. You don't pay taxes on non-existent income, for example. Vacations may be out.
The time period for those expenses may also vary. In a good economy, it may be three months. During the recession, people averaged a longer time to find a job, so nine months may have been the target.
Sybrowsky also says to take into account whether you live in a dual-income household. "If you have two tenured professors in a home and one loses his job, you still have a second income," he says. "If that is the case, you don't need as large of an emergency fund."
The type of job may also affect that amount — since a salesperson may have a more uncertain income than someone with a steadier income.
"It also has to do with a person's personal risk tolerance," he says. "If someone is uncomfortable with a lower amount I'm not going to argue with them and say they do not need to save more."
Whatever amount people set as their goal, Gallegos says to just "do the possible" and "take it slowly."
Where to save
Where to save the emergency fund money goes to the heart of the study Sybrowsky worked on. Traditional advice says to keep the fund in a easy-to-access form, such as cash or simple savings and checking accounts. The idea is that in an emergency, you want to be able to get at the money quickly.
The study found that there is a point where the emergency utility of putting large amounts of money into low-interest or no-interest vehicles goes down. At some point, it makes more sense to invest that money. But this only applies to those who have, say, a million dollars or so set aside.
"Every dollar people own should be put to its highest and best use," Sybrowsky says. "Money should be put in the most efficient place. For lower incomes, that is probably in a liquid asset like an online savings account."
Sybrowski also recommends using a money market mutual fund.
But he says to not put it in your checking account.
"You want it easily accessible, but not readily accessible," he says. "If the emergency fund is in your checking account, you can walk to the ATM and pull it out. To me, that defeats the purpose."
By having the fund just one step removed from normal finances, the money is more protected from weak splurge moments he says.
"A sale in the mall is not an emergency," he says.
Marquit splits her emergency fund into two places.
Part of it is in a high-yield savings account. "For if I need it quickly," she says.
The bulk of her emergency money is in an investment account. "It is just an all-market fund," says Marquit, who wrote the book "Confessions of a Professional Blogger."
She says most emergency expenses would be of the "bill-me-later" type — giving her time to withdraw from the investments.
Using the fund
About three years ago, after heavy rains in Logan, the water table rose and flooded Marquit's basement.
"We had to pull out the carpet and replace the pad and all that fun stuff," she says.
She also had to have the water pumped out and a sump pump installed to prevent it from happening again.
To pay for the unexpected expenses, she sold some of the investments in her emergency fund. Since she made those investments, the value of the fund had gone down, so rather than paying taxes on the withdrawal, the loss meant she could use it as a tax deduction.
She says, however, that if the investment had been doing well, she may have considered taking the money from her other more liquid assets instead.
She admits that keeping part of an emergency fund in an investment vehicle like this may not be for everyone, but that she may have a higher risk tolerance than other people.
Sybrowsky says some people become reluctant to ever use their emergency fund, once they build it up. "They hold it sacred and never use it," he says.
They may even use credit cards to avoid using the fund — paying high interest rates after the use, instead of just building the fund back up interest-free.
"The fund is a tool to be used," he says.
Sybrowsky is a case in point himself. He recently dipped into his emergency fund to pay for a family medical expense and is rebuilding the fund now.
Marquit says there is another benefit of having the fund.
"Having an emergency fund really gives me peace of mind," Marquit says. "I know if something goes wrong I can come up with the money."