Building an emergency fund can sometimes take years. There are so many things you would like to spend the money on and it never seems to take shape. However, you buckled down and now you have that spare change for a rainy day. Most financial planners, including me, recommend having three to six months living expenses in an emergency fund. If you are self-employed or the economy is poor, you may want to stretch that to nine to twelve months of living expenses. Now you have this large sum of money sitting in a bank account or money market, and you feel like you need to “do” something with it. Let’s take a look at what to do once you establish this account.
Keep it away the biggest risk
First, you need to keep it away from you! A large sum like this can be tempting to dip into anytime you need or want something. So the first step is to define what an emergency truly is and isn’t. Emergency funds are for times when you have no income, such as a serious injury and you are unable to work and pay your bills. The emergency fund will hold you over until you can return to work. An emergency is not a set of new tires for your truck. You obviously saw those coming and failed to plan!
Everyone’s definition of an emergency is different, but it should be for times that you are in need of income and cannot earn any, or a major expense that affects your personal comfort, such as a roof leak or broken air conditioner.
Keep it safe
Second, you need to keep it safe. I talked about the difference between saving and investing before. An emergency fund is not meant to earn a high return. It is meant to be there when you absolutely have to have it. So exposing it to risk is probably not a good idea. Keep your rainy day cash liquid in a bank account or money market.
Remember, it’s not about making money, it’s about keeping money.
Where to keep it
Third, you can consider a few alternatives for the amount and the account. Like I mentioned if you are self-employed and your income fluctuates from month to month you may want to use your fund to smooth out the lows. If you are employed, you still might have disability insurance to pay you part of your income, therefore, your emergency fund might be smaller.
You can place your funds in an online savings account to capture a little more interest, but make sure the account is FDIC insured. In addition, if you have a large cash pile, consider laddering CDs for some extra income. Laddering is buying varying maturities in order to keep money liquid at various times, and allow you to space apart locking in interest rates. For example, you may want to use a portion of your emergency fund to purchase a 3 month, 6 month, 9 month and 12 month CD. What this accomplishes it having your funds coming due every three months, to lock in higher yields or to avoid locking in lower interest rates.
The main thing is to have the money available should you need it in case of an emergency. You do not want to expose it to any risk, and hope you never have to use it.