Emergency Fund 101

Question: I am budgeting to set aside the recommended 6 months' worth of earnings in an emergency savings account. For me, this would be about $230,000. I have misgivings about leaving it in a regular savings account earning less than 1 percent interest. But I am also concerned about putting it in an illiquid investment that carries risk because this is rainy-day money. How do you recommend investing the funds in an emergency savings account? Peter, Cherry Hill, NJ 

Answer: I understand your dislike about tying up so much money in low-paying investments. At the same time, you're right that you want to keep the principal stable and accessible. Fact is, whether the emergency fund is made up of $1,000, 5,000, $20,000 or $200,000, the trade-off for safety is a mediocre return, one that manages to keep pace with inflation.  

However, I imagine with your savings that you have other considerable resources set aside that offer the prospect of a higher return with greater volatility and uncertainty. Depending on which investments have depreciated and which assets have appreciated at the time you need the money, you might have other resources to draw on in a pinch.   

You do have leeway. First of all, I look at the emergency fund as money you've set aside to meet 6 months to a year of living expenses. That's the goal, at least. The money is also there should something unexpected happen -- an emergency -- such as visiting a family member in another state who just had a heart attack. In other words, you tap into other savings accounts to buy a car or vacation.  

I prefer using expenses rather than income as the measure of how much you need to set aside. What do you need to meet your ongoing monthly expenses -- mortgage, insurance, food, car, utilities and so on -- should you, say, lose your job? You'll tighten up spending at the time, too. How much to set aside depends on a number of factors, from monthly bills to job security to what's realistic. (The latter is the most important factor for many families.) 

Secondly, should you need to tap the money, you usually don't withdraw it all at once. You spend some of the savings (visiting an ill family member in another state) or over a period of months (meeting living expenses while looking for a new job). Time gives you a bit of leeway.  

For most people, since the emergency fund isn't very large, it's simplest and easiest to put it into a federally insured online savings account or comparable account.  

Since you have a substantial sum of money, you might want to consider taking some of it and creating a short-term ladder, perhaps with short-term CDs, 13- and 26-week Treasury bills (bought directly from the Treasury) -- that type of investment. Again, in today's unusual interest rate environment, you won't make much on the savings, but maybe in aggregate it will be a bit more than the typical savings account.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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