Building an Emergency Fund

November 29, 2012

Rob Williams
Director of Income Planning, Schwab Center for Financial Research

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 or going out to movies, or attending 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. And if your home price falls, the value of the credit line may either be reduced or frozen at the time when you need to draw from it. 

Many options are better than under your mattress

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 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 non- interest -bearing checking account. Interest rates on most types of cash investments may be low now, but there are better options available. Among them:

1. High-yield bank checking or savings accounts. They may provide a slightly lower yield than money market funds, but they offer immediate liquidity and are FDIC-insured up to $250,000 per depositor, per account type, per insured institution. These usually have minimum requirements to be eligible for the higher yield, so look closely at the account requirements.
2. Short-term bank CDs. Also FDIC-insured up to $250,000 per person per institution for each account ownership category, CDs typically offer higher yields than the option 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 CD maturing every few months, then rolling over each CD when it matures.
3. Purchased Money Market Funds. Purchased money market funds may be an option for emergency reserves but they do not offer immediate liquidity. Clients must sell their funds to access their cash, and assets are generally available next day if sold by 1:00 Pacific Time. In addition, although money market funds seek to maintain the value of the client's investment at $1 per share, it is possible to lose money investing in them.