One of the first things I tell friends when they are looking to set aside some emergency fund cash is “make sure it’s earning something… even just a little!” But let’s back up.
What’s an emergency fund, and how much should that realistically be?
What is an emergency fund?
An emergency fund is money set aside that you can use when facing times of financial distress. This "rainy day fund" can provide a sense of security as it creates a safety net to meet unexpected life expenses.
How much cash should you set aside?
An emergency fund, for the average worker, should be a minimum of two months of your annual salary. Some folks recommend setting aside three to six months of your average expenses, with minimal discretionary spending. Make sure to include your “hardline items” like rent/mortgage, car payments, utilities, basic groceries/gas, insurance premiums. If you have already set aside 2-3 months of those expenses, consider adding a little to the pot for discretionary funds (entertainment, clothes, eating out, etc.) that might help lighten the burden during a financial hardship.
The funds should be someplace liquid (not tied up in the stock market or real estate) making it easily accessible for when you… have an emergency! A car breakdown, unexpected health issues, an emergency vet bill or sudden childcare expenses could be events for which you can tap the emergency fund. It’s a safety net for those unexpected expenses that seem to come up right after you paid for holiday presents or that annual vacation. These funds should be used for an actual emergency: losing your job is an actual emergency… elective plastic surgery is not. Starting even a small emergency fund of $500 to $1500 could help stave off high credit card fees and financial stress.
"Losing your job is an actual emergency... elective plastic surgery is not."
Where can you invest the cash while it sits?
Right now, a savings account at your bank is likely earning 0.01%... which doesn’t help grow the funds while they sit, hoping to never be used. I suggest investing the emergency funds in a money market savings account. You can link the account to your checking account, which allows for easy transfers when needed. As you are able, you can deposit funds into the account each month to build up a comprehensive emergency fund for better peace of mind and financial security.
American Express offers a personal high yield savings account with a floating interest rate (as of 4/1/23 it was 3.75%). They have a 7-day minimum hold for any funds placed in the account (which is low, and I would argue if you know you need the money in the next week, why did you put it in the emergency fund?). There is no minimum balance and no fees. Your funds are FDIC insured up to $250,000 per account. There are several other banks that offer these types of savings accounts: Capital One and Discover Bank (currently 3.6%). I have some cash in Discover Bank because they did a special intro offer a few months ago, but I’ve stuck with American Express because I already use them for my credit cards and have experienced great customer service --- it’s a name I trust.
If you Google “high yield savings accounts” several dozen banks come up. I would caution you to choose one from a national brand, with great customer service, no fees or minimums and FDIC insurance. These are essentially money market accounts and do have some exposure to the stock market, however, your principal (the cash you put in) should be secured. Make sure you aren’t investing in a fund or account that your principal is subject to loss (meaning if you put in $100, you might only get $95 back). While $1500 will only yield $56.25 right now, that’s more than the $2.25 you’d earn at your local bank each year. As the Fed funds rate increases (short term interest rate set by the FOMC) these money market savings accounts will increase their return as well. It allows you to better keep up with inflation yet have a very liquid safety net for emergencies!