Back to Basics: Building an Emergency Fund

One of the most boring but essential pieces of a successful financial plan is creating an emergency fund. Without it, a plan can fall apart instantly. In this article we will discuss what it is, why you need one and how to set one up.   

What is an Emergency Fund?

Regardless of your net worth, risk tolerance, or investment philosophy you need an emergency fund. An emergency fund is an account that is held separately from your normal checking and savings accounts whose purpose is to cover unexpected expenses. When you get hit with a vet bill or a hot water heater breaks, you use the cash in your emergency fund to cover it. An emergency fund allows your invested assets to stay invested, while still covering your expense needs. 

How much should I have in an Emergency Fund?

This is a topic that is always up for debate. The general rule of thumb is that you should have 3-6 months’ worth of expenses saved. Generally, the safer your job security is, the less you need to have saved in an emergency fund. If you are a teacher of 20 years you can keep closer to 3 months’ worth of expenses in your account knowing you have very little risk of losing your job. On the other hand, if you own your own small business or work on commissions where your income is not guaranteed, you should probably have closer to 12 months saved. How much you keep saved in the fund is often a personal preference, some like having less in the fund and more invested while others sleep better at night knowing they have a years’ worth of expenses covered should something happen.

Setting up and managing your Emergency Fund

We always recommend keeping your emergency fund in a separate bank than your normal day to day checking and savings accounts. This way you are not tempted to move funds over to buy something nice for yourself. We would recommend a high-yield savings account offering a decent yield. Although interest rates are at all time lows, it is still better than nothing.

The idea is to always have your emergency fund “full”. So, if you need to take out $400 to cover a bill, you should pay back your emergency fund as soon as possible before making any other investments.

There have also been debates recently on whether you should invest your emergency fund. Our recommendation again would be to keep it in a high yield savings account with FDIC insurance and daily liquidity. Although it seems like the market is going up every day, it won’t last forever. The last thing you would want is for your emergency fund to lose money when you need it the most. The fund is supposed to be a safety net that helps you sleep at night, not another investment vehicle.

This article is part of our Back to Basics series helping families cover the basics of financial planning. Our next article will cover insurance, and the importance of being fully insured.

Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments