Everyone suffers a bad day now and then. An emergency fund can make a bad day temporarily painful instead of a long term burden.
Without emergency savings, people may need to resort to credit cards, payday loans, or worse! Let’s first examine why you, and everyone else, needs an emergency fund, then we’ll examine the general stages and safe investments for emergency funds.
Over Half of Americans Are At Risk
The Motley Fool studied the Federal Reserve’s Survey of Consumer Finances from 2022 and found both good news and bad news. The good news is that the average American saves more than ever before, but the bad news is that many Americans remain at risk.
The median bank account balance for American households reached $8,000 in 2022, nearly twice the $4,780 balance recorded in 2010. This includes checking, savings, money market funds and more.
However, the same survey showed that only 45% of Americans can afford to cover a $400 expense with funds from their checking or savings account. A single car repair could suddenly become a recurring charge on their credit card
When A $2,000 Repair Costs $4,456
Let’s assume you suffer a painful $2,000 car repair. You need your car, so you have to pay, but if you were one of the 55% of Americans who doesn’t have $2k in an emergency fund, then you probably put it on a credit card.
Many people will just make minimum payments on their credit cards so they don’t have to disrupt their normal spending habits. However, the average credit card rate is 20.99% APR, and Lending Tree calculates that the $2,000 auto repair would cost $4,456 dollars and 11 years to pay off making minimum payments!
An emergency fund capable of paying off the $2k repair would allow you to keep the $2,456 difference instead of gifting it to your credit card company! Yet it could be even worse, because this is the average APR.
That means many Americans pay even more in interest rates. To explore your own scenario, you can use the Motley Fool Credit Card Calculator to play with some numbers.
Also, in the example above, we assume you will only have one emergency to cover, but it is very common to experience a financial emergency of some sort every couple of years. During that 11 year payoff, how many other costs will be added to the credit cards without an emergency fund to cover them?
How to Set Aside Funds
Creating an emergency fund is a process, but not a difficult one. Just one that requires patience and planning.
Your emergency fund process will be a series of three general stages as your types of emergencies evolve and your financial sophistication increases. When you start, stage three will seem out of reach, but the sooner you begin, then the easier it will be to make progress.
Stage 1: Just Save Some Money
Just start. This will probably be the first time that you begin to pay yourself first, so you just need to start somewhere and save what you can – $100 or even $10 a month is a good beginning.
I started with aiming for $1k as my target for my emergency fund balance back in 1995 because it was also the minimum balance for my checking account. But car repairs cost more now so the target total should be over $3,000 in 2026 if you own a car.
Where do you put the money? We started with our checking account, but eventually moved our emergency fund to a savings account for better interest payments. By linking our accounts, we met the minimum balance requirement for our checking account too.
For now, you’re just trying to protect yourself against small emergencies. Anyone creating their first emergency fund is fine in this stage, and if you are young, you likely don’t have as much to lose.
Just start.
Stage 2: Save For Larger Emergencies
It may take a few years to find success saving money up in Stage 1, but both pay increases at work and experience in saving money makes the process easier. However, you’ll also start to have more obligations for your funds like rent, furniture, appliances, phones, and computers.
With more things in your life, there will be more opportunity for loss or an emergency. Your car will have its catalytic converter stolen, your friend will spill a soda down your laptop keyboard, or your neighbor will have a fire in their apartment that makes all the clothes in your closet smell like smoke.
Stage 2 is about saving for more serious emergencies and larger costs. It is also about protecting your emergency funds and getting a larger return on your money.
Target a minimum of $3,000 in emergency funds with an eye towards increasing it to $6,000 or even $10,000 over time. With this amount of money, don’t keep the funds in the checking account making a pitiful amount of interest.
Start looking for options with higher interest rates (at least over 1%) such as high-interest savings accounts, money market accounts (Vanguard’s Federal Money Market Fund pays around 3.6% as I type this), a treasury bond fund (ETF or mutual fund), or a Certificate of Deposit (CD) at the bank.
CD Ladders
One option with CDs is to create a CD ladder similar to the bond ladder in the Treasury Bond Article that illustrates how $10k a year can grow to $590k in thirty years. The same math still works for smaller amounts of money for emergency funds even if the totals will be less impressive.
Maybe you can save less than $100 per month, but that could add up to $1,000 per year for your emergency fund. After 10 years in a checking account you will have $10k in your emergency fund.
However, you might get tempted to spend the funds just sitting there. Yet you also don’t want to lock the money away for too long because then you can’t use it in an emergency.
Consider creating a ladder for the funds in CDs. You could start with three month CDs after you save $3,000, but the interest rates at many banks for 90 day CDs are not much better than a checking account.
However, after you save up $6,000 you can buy a six-month, $1,000 CD every month for six months. This creates an income stream of maturing $1,000 CDs plus the generated interest becoming available each month..
My bank offers a 2% annual interest rate for such a CD (and you can find better rates out there). Using a CD interest calculator shows that will earn you $1.67 in your first month for each CD, and by the time the CD matures in 6 months, you’ll have over $10 in interest.
This won’t make you do flips around your house, but it certainly is better than the amount I can earn over the same time period in my checking account. Even if you do have an emergency, you will benefit from small earned money versus losing big money by putting the emergency charges on a credit card.
If you can avoid an emergency and you continue to add $1k at the end of each year, then four years later, you will have added $10k to your emergency fund but have over $10,500 including interest. This won’t make you rich quick, but it will help you create a robust, protected, and growing emergency fund as you head into Stage 3.
Stage 3: Save For Life Changes
Ten years sounds like a lifetime away – and at your age my children, nieces and nephews, it is. Yet, trust me, it goes by super fast and only gets faster. In my feeble mind, you were just born yesterday, so it is hard to come to grips with your 15th, 22nd, and even 30th birthdays!
As you get older and get married, have kids, or simply get more ambitious (bigger car, better job, maybe even a house), you will need more money and emergency funds. In stage 3, you should target 3-6 months of pay from your job as the amount you need to save. If you are really ambitious, save up a year’s pay.
Saving this amount of money helps you if you need to quit your job, get laid off, have a car accident, go on maternity leave, care for your aging parent (…don’t worry kids, this should still be a ways off), or exterminate the rats in the attic.
A checking account will absolutely pay too little to keep this amount of money sitting there. The other options covered in stage 2 will still work, but you also have a third option – a Roth Individual Retirement Account (Roth IRA).
When you work, you can put money into a traditional (tax deductible) or Roth IRA (not tax deductible). This account should primarily be a retirement account, but it can also be used in emergencies.
In a traditional IRA, you can pull money out for emergencies, but you will probably pay a penalty and you also have to pay taxes on the funds. Only use the traditional IRA or 401k loan as a last resort.
A Roth IRA will allow you to earn money tax free and pull out your original contributions tax free without penalty at any time. So if you put $5,000 in a Roth IRA and 3 years later you have a $5,000 emergency, you can pull out the $5,000 without any penalty or tax!
There are two key points to keep in mind. First, you can’t pull out the gain (interest, dividend, or investment increase) on the contribution and, second, you will need to document the date and amount of the contribution, so keep good records!
Now I hear some of you saying – but my IRA is for retirement, I don’t want to use it as my emergency fund! I hear you, but sometimes it is hard to save for both. Also, you are only supposed to use your emergency fund in an emergency and not just when it is convenient.
You can keep some money in a regular emergency fund. Just consider the tax free growth benefits of the Roth IRA as a good place to store a portion of the funds for larger emergencies.
Safely Store Emergency Funds
Since this is an emergency fund, don’t put the money into commodities, bitcoin, or other options for investments that go up and down a lot. After all, in an emergency, you want cash quickly and you need what you need. Emergency funds require liquid, stable investments.
As I covered in more detail in Working Money, liquid investments can be sold quickly or redeemed to be converted into cash. Stable investments don’t move much in price which also means you can depend upon the amount of money you will receive if you are forced to sell.
Commodities and cryptocurrency can go up in value, but can also be down in value for years at a time so you don’t want to be forced to sell at a loss for an emergency. Similarly, real estate also can go down in price, but suffers the additional difficulty of being hard to sell – which makes it a bad choice to store money for an emergency.
Stock and funds are tricky because you need to select the right one. Tech-focused investments will be very volatile and can go up and down dramatically. The up is great, but the down makes it terrible for emergency fund investments.
Treasuries, bond funds and money market funds won’t have quite the upside of tech stocks, but they will be very stable and safe for emergency funds. If you prefer stock investments, look for stocks with a beta value less than 1, which means the stock is more stable than the stock market average (which is defined as a beta value of 1).
The Cabot Wealth Network published a list of the highest-yield (in February) stocks from the S&P 500 (part of SPY and similar index funds) with the lowest beta and most financial sites, such as Yahoo or Google will also list the beta. Low beta stocks can make excellent emergency fund investments and you can also look for low beta funds such as the Vanguard US MInimum Volatility ETF (VFMV).
As an example, if you buy Conagra Brands (CAG) you can have a stock with a Beta of -0.02 which means if the stock market goes down by $100, CAG actually tends to go up by $2. Of course this also can go down by $2 if the market goes up by $100, but this is also offset by the 4.48% current dividend. This results in a stable, emergency-fund appropriate, investment with upside income.
Start Now and Build Habits and Funds
Emergency funds pay for themselves by making your life more stable and less stressful. They also provide a good way to practice living on less than you earn and to save money for other activities such as travel or investing.
As you find yourself capable of saving for emergencies, you may also find the ambition to save for other things like travel, a house, or retirement. You can duplicate your success in saving for emergencies by also saving for these other items.
You may find the stages of development for these items very similar to saving for your emergency fund and you may eventually create separate accounts. As with emergency funds, you will find that the earlier you start, the more quickly you will be able to reach your targets.
Just don’t dip into emergency funds for these other activities! Unless they overlap… such as raiding both the house fund and the emergency fund after discovering rats in the attic…