Why You Need An Emergency Fund:
The primary purpose of an emergency fund is to carry you and your family through difficult financial times in a manner where you would not have to tap into other sources of income or your personal assets at the time of an unplanned emergency.
An emergency fund would provide funds so that you and your family would not have to use credit, retirement funds, borrowing and/or investment funds or other means if you and your family were faced with a sudden and unexpected event.
Unexpected emergencies (job loss, major appliance repair or replacement, heating and air repair or replacement, automobile repairs etc.) seem too happen all too frequently when you don't have an emergency fund—less so when you have a properly established emergency fund.
Emergency funds are meant to be there when you need them and should be invested in money market or other low risk accounts such as savings, CD’s etcetera.
With the return on savings rate so low now, many are looking for higher returns by going online to find savings accounts that offer a higher yield. Be sure you are aware of the restrictions and make sure you thoroughly understand the fine print if you are searching for a higher rate of return.
You can go to bankrate.com to make sure that the banking institution earns at least 3 stars for safety.
Also, consider longer term CD's that offer higher interest rates but have low penalty fees for early withdrawal.
Again, be aware of the fine print and pay special attention to penalties.
If you are forced to withdraw early you want an account that will still give you a good effective yield, therefore be sure to find a company that has low penalties or fees for early withdrawal.
You can go to bankrate.com/cd
to learn more about banking institutions that offer low penalty CD's.
Use Caution If You Are Considering I Bonds In Your Emergency Fund Portfolio
Although, not often looked at by many, an I Bond is another relatively safe emergency fund option.
An I Bond is a bond issued by the U.S. government and is reset twice a year to keep up with inflation.
As of 08/2011 the rate was 4.6% on an annualized basis, however there is a five year holding period and a $10,000 annual investment limit. If you pull your money out early there would be a penalty.
Lets say you pull your money out after 12 months—you would still earn over 2% which is still higher than what most banks are paying now (average of less than 1% at most banks as of 08/2011).
If you purchase an I Bond and the new rate goes up at the time of future resets you could earn even more.
You can buy I Bonds at your local bank or log on to treasurydirect.gov to purchase and learn more about I Bonds.
Keep in mind that you can't redeem an I-Bond for one year. A staggered purchase approach—or utilizing a portion of your emergency fund balance would be a more reasonable approach than using your total emergency fund for the purchase of I Bonds.
If you were to seriously consider I Bonds in your emergency fund you must factor in the holding period as "emergencies" do not respect the one year holding period—or any holding period.
On some occasions I have worked with clients who used conservative bond funds in their emergency fund.
A bond fund with an attractive yield (say—4% to 10%), low risk, and sound investment strategies (such as government backed securities, medium-term U.S. and corporate bonds at the right mix) and experienced management may appear to be a safe place to park emergency fund money—however, when interest rates rise the bond price will fall.
If you were to actively monitor your future risks by staying aware of market data such as interest rate movement (upward movement of the ten-year treasury yield) you could come out ahead if you moved the money in a timely manner to safer areas such as a money market account.
However, for most emergency funds—a bond fund is still not the ideal place to park money for a true emergency—even though the risk of loss may not appear that great on the surface.
Why Many Have Difficulty Establishing An Emergency Fund
Emergency Funds are often difficult to establish for many due to inadequate income (all income is needed for daily living), lack of focus, lack of awareness and with many they just plainly don’t want an emergency fund as they feel all of their income outside of daily living should be invested in assets that provide a better return than that of a money market account or CD.
This can often be the wrong approach as the account could lose substantial value. However, many use this approach due to not properly understanding the "purpose" of an emergency fund.
Again, be sure to utilize low risk savings vehicles for your emergency fund!
It is also important that you establish an emergency fund at the earliest time possible. The earlier in your “financial life phase” that you establish an emergency fund—the more effective you can be at attaining your other financial goals and objectives.
Establishing an emergency fund at the earliest time possible is an important step in “improving your financial position” and that of your family's.
Aim for a 6 month emergency fund (6 months of salary—or 6 months of living expenses) at a minimum, and build on that even more if you see the need to do so.
Also, be sure to avoid unnecessary fees:
Be sure not to tap into your emergency fund unless there is a "true emergency" and be sure to avoid monthly or recurring fees for inactive accounts.
To avoid inactivity and other fees you may have to set up monthly deposits of a low amount or utilize other creative ways to avoid inactivity fees.
You must be aware of all of the fees involved at your institution and you must find a way to reduce or eliminate those fees if they negatively affect your emergency fund!
Note: If you are highly skilled or you are in position to gain employment fairly quickly due to your skills or connections that you have, you may not need as high an emergency fund balance as those who are not as skilled or not well connected. However, generally speaking a 6 month or more emergency fund is normally adequate for most. Use your better judgment to determine the optimal emergency fund balance that is best for you and/or your family.
Debt Payoff or Debt Reduction Is Critical for Your Success
Closely related to establishing your emergency fund is to keep your credit card balances low and pay off your balance monthly.
You don't want to be in a position where you are paying credit card debt at 15% or more and you have a 6 month emergency fund where you are earning 1% to 5%!
Be sure you are in position to pay off your credit card balance monthly after your emergency fund is established.
Doing so will not only maintain and improve your credit score—but will provide you with a properly funded emergency fund that can be used for true emergencies.
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