Building an Emergency Fund

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Building an Emergency Fund
by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
Updated June 3, 2009

Updated from the September 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

A myriad of unpredictable events could hit when you least expect them. The most common fear may be losing a job, but illness or death, an accident or simply a reduction in income due to an economic downturn could all wreak havoc on your finances.

We recommend keeping at least three months of essential living expenses as a "rainy day" fund. That way, if something bad does happen, you can avoid costly alternatives like borrowing at high rates on credit cards or tapping into retirement funds, such as 401(k) plans or IRAs, and paying taxes and penalties to boot.

You'll also avoid having to sell long-term investments at what might be an inopportune time. And, if you do lose your job, an emergency fund will give you some breathing room to be thoughtful about your next job opportunity rather than feeling pressured to accept the first offer that comes because, financially, you feel you have to.

An emergency fund isn't just for lower-income people who live paycheck to paycheck—many high earners live close to or beyond their means, maxed out on credit card debt and with large mortgage payments or other obligations.

Even if you have a high net worth, your assets might be locked up in illiquid investments. When high earners must seek new employment, the search usually takes longer, and the next job could be at lower pay; an emergency fund can help smooth that transition. And even insurance payouts for whatever calamity arises may take a month or more to reach you.

How much is enough?
It's not enough to just multiply current monthly expenses by three—it depends on your particular situation. Is your spouse working? If so, you might not need as much to weather a job loss—you may save on transportation or child care. Perhaps other sources of support, like your parents, are part of your backup plan (if so, let them know!).

Think long and hard about what you really need money for:

Nondiscretionary expenses: true essentials. Estimate costs for food and shelter. Include rent, or if you own your home, mortgage, property tax and home insurance, plus utility costs. Add in car payments and expenses, including auto insurance, maintenance and fuel costs. And if you have outstanding credit card bills, you'll at least need to keep up with the minimum monthly payments.
Discretionary expenses: cut what you can. Clearly you can trim back entertainment costs like dining out, renting DVDs, or going to concerts or ball games. But are there other opportunities to cut costs? Cable TV or a gym membership might seem essential now, but perhaps you can cut those during the hard times.

Note that some expenses may increase: If you lose your job and must pay the full cost of health insurance, it will likely be a lot more than what you pay now. Or, if you must leave home due to a natural disaster, you may have additional housing and living expenses.

Is it too daunting a task?
We often receive feedback that the idea of an emergency fund makes sense, but that it's too daunting to create one. It doesn't have to be.

Begin by adding up the money you now have in cash or other liquid assets.

You needn't think of your emergency fund as a single entity—you might effectively have one between existing checking or money market accounts, bank CDs and short-term U.S. Treasuries. Once you see what you already have, try to build up any shortfall as quickly as reasonably possible.

Another key source to consider: A home equity line of credit (HELOC) can serve as a nice backup in an emergency. If you do take this route, it's important to have the line in place before you need it. One caveat: It is a loan that you'll have to pay back, and an adjustable rate could be high when you actually need the cash.

Many options are better than under your mattress
	Pros	Cons
Short-term bank CD	Generally higher yields than options below, FDIC-insured	Locked up for duration (can tap early with penalty)
Money market mutual fund	Decent yields available, next-day liquidity	Though considered safe, not fully guaranteed
Traditional interest bearing checking account	FDIC-insured, very liquid (checks, ATMs), slight yield	Slightly less yield than options above
Home equity line of credit	Money is available, but you don’t need to save it	If line is tapped, must be paid back with interest

How to invest your emergency fund
Another criticism of emergency funds is lost return opportunities. But having such a fund doesn't mean the money can't work for you. The investments below may not have the return potential of high-flying stocks, but the goal of your fund is risk reduction. The rate of return on auto insurance isn't great either, but you still have it.

The worst place to keep an emergency fund (well, besides under a mattress) is in a 0% or near 0% interest-bearing checking account. You may scoff, but you'd be surprised how many people do just that when there are better options available. Among them:

Money market mutual funds. These funds offer check-writing privileges (over certain minimums) while generally providing a decent yield.
High-yield bank checking accounts. They may provide a slightly lower yield than do money market funds, but you can write checks for any amount and may have easy ATM access to cash. Bank deposits are FDIC-insured up to $250,000 per person at a single institution through December 31, 2013¹.
Short-term bank CDs. Also FDIC-insured up to $250,000 per person per institution, CDs typically offer higher yields than the options above. Although money invested in a CD is locked up until it matures, you can withdraw early and pay a penalty if you really need cash. One way to avoid having all of your funds locked up is to create a CD ladder, with one maturing each month, then rolling over each CD when it matures.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

An investment in a money market fund is neither insured nor guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund. Please note that bank deposits are FDIC insured up to $250,000 per person per institution through December 31, 2013 while nonbank independent products have no such guarantees.

1. The temporary increase of FDIC insurance coverage to $250,000 for all insurable capacities has been extended through December 31, 2013. If not further extended, FDIC coverage will revert to $100,000 on January 1, 2014 for all insurable capacities except IRAs and certain other self-directed retirement accounts and plans. Unless the increased coverage is extended, deposit insurance coverage for CDs with a maturity date after December 31, 2013 will revert to the prior FDIC coverage on January 1, 2014, regardless of when you purchased the CD. You should not rely on a possible extension of this increased coverage in purchasing CDs.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Past results are not indicative of future performance.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Brokerage products offered by Charles Schwab & Co., Inc., are not FDIC insured, are not deposits or guaranteed obligations of a bank, and are subject to investment risk.

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