One of the most important things you can do to secure your financial freedom is to have an emergency fund. Emergency savings can provide you with a way to prepare for the unexpected expenses that can sometimes come with life. Your emergency fund allows you access to money in difficult circumstances without the need to resort to borrowing. (Or borrowing as much as you might have otherwise.)
It is possible to create one large emergency fund, and keep short term and long term savings in the same pot. However, there is something to be said for dividing your emergency savings into two different accounts. This is especially true if you keep your long term emergency savings in a CD ladder, or in an online savings account that you may not have immediate access to.
Characteristics of an Effective Emergency Fund
There are some characteristics that make an effective emergency fund. One of the most important items to consider is liquidity. Most emergency funds are kept in cash because it is liquid. You have to arrange to sell stocks, bonds and other securities. This can take some time, and some assets are hard to liquidate into cash than others. Keeping an emergency fund in cash may mean lower yields, but it also means that you don’t have to go through extra selling steps to end up with cash.
Another consideration is access. An emergency fund should be accessible. If it’s not, then it isn’t much good, since you won’t be able to get your money in a timely manner. Those who use CD ladders when setting up emergency savings often arrange matters so that a CD matures regularly, on a predictable schedule, so that money is available every two or three months. With online savings account, it can take three to four days (or more) in some cases to get access to your funds. This can limit the usefulness of an emergency savings account in a tight pinch.
For the long term, though, CDs and online savings accounts can be very effective, since they can offer quite competitive yields, and when you are in a situation where long term funds are desirable, you might need access immediately. However, if something like car repairs or a broken major appliance results in the need for immediate access to emergency cash, an online savings account or CD may not offer the access you need. This is where having a short term emergency fund might come in handy.
Setting Up an Account for Short Term Emergency Savings
Some online savings accounts offer ATM cards that provide you with access to your funds from a machine. This can be one way to ensure that you have immediate access to emergency cash. However, if your online savings account only offers the option to transfer money into your checking account, it can put you in a bind to wait for the transaction to go through. As a result, some find it preferable to set up a smaller, short term account in a more accessible local credit union or bank.
One of the downsides to using a more traditional savings account is that the yield on such an account is usually quite low. It is difficult to find a competitive interest rate on a traditional savings account. You are trading a higher yield for immediate and convenient access to your money. In order to get around this, some prefer to open a money market account.
A money market account can be a good choice for short term emergency savings, since many of these accounts offer competitive interest yields, while also offering easy access via ATM card, debit card or check. You should remember, though, that a money market account is still a savings deposit account, and there are limits on the number of withdrawals you can make each month. On top of that, there might be minimum balance requirements, or monthly fees. Be sure to check account terms and conditions before opening any type of savings or money market account.
How Much Should Go Into Your Emergency Savings Accounts?
Once you have decided to divide your emergency savings into different accounts, you need to figure out how much money should go into each. For long term emergency funds, the recommendation is six to nine months of expenses (or even 12 or 18 months of expenses). Your long term emergency fund is designed to help you support yourself if you lose your job, or have your hours cut, or end up with massive bills due to some catastrophe. A long term emergency fund is meant to help you cope with bigger expenses.
Your short term emergency fund, though, can be reserved for more mundane issues. If your washing machine breaks down, or if you need car repairs, a short term emergency fund can provide you with a way to cover these unexpected expenses without straining your monthly budget, raiding your long term fund, or without putting it on a credit card. A short term emergency fund of between $1,500 and $4,000 is usually sufficient to cover most low grade financial surprises. Many people like to put one month’s worth of expenses in the short term fund. After you have covered your expenses, you can replace the money in your fund. (I also like to use the money in my short term fund to cover any tax shortfall I might have.)
Another good use for your short term emergency savings is to help cover relatively small expenses and bills while you wait for access to your long term emergency savings. This can be a way to pay for expenses if there is a month or so before the next CD in your emergency ladder matures, or to serve to cover you while you wait for money from your online savings account to be transferred into your checking account.
In the end, dividing your emergency fund up so that you have immediate and easy access to at least some of your money can be a helpful way to make sure that your expenses will be covered, and you can almost always get the money you need.