If you frequent any form of personal finance websites on the internet, you will hear the term, ‘Emergency Savings Fund’ a lot. What is this account type, and how does it differ from the traditional savings accounts we all know and love?
Emergency funds are reserved for unexpected financial events, whereas normal savings are things you can plan for. You should build up 3-6 months of expenses, and place it in a high yield savings account so you are prepped for the worst.
Emergency Fund vs Savings: What you Need To Know
What you Need to Know
What Is An Emergency Fund
An emergency fund is the most powerful weapon in your financial arsenal. While it is awesome to be able to watch your retirement savings grow, or your debt falls to the wayside, an Emergency Fund will be able to save you on your darkest days.
It is advised that you should keep 3-6 months of your expenses for your emergency fund. What exactly is the fund for? Well, while many people believe they are strictly for unemployment (thus why you should keep 3-6 months’ expenses), there is a whole host of obstacles life may throw your way. The typical ones include:
- Medical emergencies
- Property damage
- Car damage
However, this is by no means an exhaustive list!
My own personal example is when doing a cross-country move with the Navy. I was required to pack up and move all possessions across the country, paying out of pocket for rental equipment, gas, and hotel stays, and I wouldn’t be reimbursed until 6 months later.
I was saved solely on the fact that I put that money into my Emergency Fund years earlier, otherwise, I would have had to have risked putting it all on my credit card and hoping I could pay it off quickly.
On the other hand, a normal savings account is for things that you CAN plan for. These are events that come with a high enough cost that you need to save up for them, but not so big that you have many years for the money to sit in the stock market (retirement). Typical things to save for include:
- Down payments for a house
Just like before, this is not meant to represent anything and everything you could save for.
What is important is understanding that emergency funds and savings funds are SEPERATE. I personally choose to use two completely different banks (Ally Bank & Yotta HYSA) to store my savings and emergency funds respectively, just so I don’t confuse the two.
If you do opt to use one bank, make sure you know what portion of the savings corresponds with your Emergency Fund.
Where Should You Put Your Savings?
The thing these accounts share is where you should put this money. Ideally, we want to put this money into what are known as High-Yield Savings Accounts (HYSAs). Don’t let the word scare you. These offer the same exact protections as normal savings accounts (FDIC insured), but with 12x the national average interest rate.
Many of these banks are able to offer so much extra money in interest by severely limiting the amount of brick and mortar stores they have open. While in the past having a purely online bank would be seen as a disadvantage, in today’s environment you can conduct almost any transaction you wish online easily.
CAUTION: While some people may advocate using a certificate of deposit (CD) as a vehicle for an Emergency Savings Fund, I will strongly recommend against it. Not only do you incur fees if you withdraw your money early. You may actually wind up locked in at an interest rate that is less than an HYSA.
It’s just not worth your time.
How Important Is an Emergency Savings Fund?
If you have been here long enough, you will understand that establishing an Emergency Savings Fund is the very first step in growing your wealth.
To drive this point home and illustrate why, let’s examine two different options you could be doing instead of building up an Emergency Fund, and explain the associated risks.
Paying Off Debt:
While aggressively paying off debt is almost always a great decision, without an emergency fund, it comes with substantial risks. Imagine that you do lose your job. Rent still needs to be paid, the phone bill is on its way, unpaid car loans, etc. The way most Americans would deal with this situation if they lack sufficient funds is turning to credit cards, and risk burying themselves in debt by racking up 24% APR on potentially thousands.
Investing For Retirement:
Investing for retirement is an excellent goal to put your money towards each month. However, without a solid stash of easily accessible cash, any unexpected financial hardship can quickly turn into a nightmare. If you were to be forced to pull money from your Roth IRA / 401(k) / Thrift Savings Plan, you would be not only hit with exuberant fees but may also be forced to sell off assets in the middle of a downturn.
*Both of the above situations are easily avoided by an Emergency Savings Fund. It will ensure you can deal with life’s unexpected obstacles without putting you into more debt, or throwing away your retirement savings. Start today by aiming to contribute 10%+ of your monthly paycheck into a separate HYSA to be ready for whatever tomorrow brings.