“Am I Ready to Invest?” Part 3: The Emergency Fund Account

If you’ve been reading the blog in order thus far, you’ll recall that we’re in the middle of a series of posts about knowing when you’re ready to invest and about the foundational items that need to be in place prior to any significant investing. One of these foundational items is the emergency fund.

Recapping the discussion of the emergency fund to this point, we’ve talked about how an emergency fund is essential to investing success and how much money should be in your emergency fund. Now it’s time to address where your emergency fund should be held.

Gone are the days of stuffing the cash for an emergency fund or other savings under the mattress, burying it in the backyard, or hiding it in some “secret” place in the home. Or at least those days should be gone. (Please don’t do this. Seriously.)

Instead, your emergency fund needs to be in an account at a financial institution where it can be accessed, transferred, and used easily when needed.

There are several options out there when it comes to accounts for an emergency fund–some good, some not so good. The key consideration for an emergency fund is that, under all circumstances, it must be both safe and liquid.

“Safe” means that it is not in any risky investments. You should take very little risk with an emergency fund, as you cannot afford to have the emergency fund balance down due to market conditions when you need the money. “Liquid” means that you must be able to convert this money to cash quickly (if it isn’t already in cash) and access it as immediately as possible.

After all, an emergency fund is for emergencies, and when emergencies happen, we don’t take our time. If my car breaks down and I need the money to repair it, I need it now without any complications at all, right?

With such safety and liquidity in mind, that presents us with four options:

1. A traditional checking/debit account

You could save your emergency fund money in a traditional checking/debit account that is an entirely separate account from the normal checking/debit account you use on a regular basis.

Note that I specifically said a separate account. Do not, under any circumstances, keep your emergency fund money in the same checking/debit account you normally use for living expenses, paying bills, etc.–it will be all too easy to tap into it for purposes other than a true emergency.

But even if you do keep your emergency fund account entirely separate, this account type as a possibility for your emergency fund still isn’t ideal. Why? Because nearly all banks will pay you nothing at all for having your money in a checking account, unless you carry (and keep) a high balance, and even then, there are better options (see below).

If your emergency fund is intended to stay put until it’s needed, you want it to be earning money while it’s sitting there unused. I mean, why wouldn’t you? Earning something is better than earning nothing. When it comes to earning a return, most checking accounts are ruled out.

A traditional checking/debit account for your emergency fund? Nope.

2. A savings account at a traditional bank

A savings account at a traditional bank with physical branch locations is a step above our first option, but not by much. Why? Because savings accounts at traditional banks currently pay pitiful (and I mean pitiful) interest, often .01% to around .07%.

If I left my $1,500 emergency fund sitting there in a traditional savings account at my local bank branch for 40 years and received .01% in interest, at the end of 40 years, I’d have a grand total of, oh . . . $1,506.01.

Yes, you read that correctly: 40 years for $6.01.

Or if you want to look at it another way, I would double my $1,500 in roughly 7,200 years. While I find that math depressingly fascinating, 7,200 years is just a little beyond my investing lifetime.

What if you insist on a traditional savings account, though, because you really like your local bank, the people there call you by your first name when you walk in the door, and they smile at you a lot? Sure, your money would be safe in such an account, and the people at your branch may be nice and helpful folks, but that actually comes at a cost (ultimately to you).

Among other costs, your bank is paying for the direct cost of operating a physical branch; they aren’t going to be paying you to hold your emergency fund in a traditional savings account. They gotta pay for all those lollipops somehow, right?

3. A high-yield savings account with an online bank

Now we’re getting somewhere. Online-only banks (or banks whose operations are predominantly online) are able to save a substantial amount of money by serving customers online rather than at branches. Generally, these banks do not have any physical locations. But what you lose in the ability to walk into a building and talk with a human being face-to-face, you gain in other benefits.

Given their online focus and their need to remain competitive for online customers, you’ll often find them offering what are known as “high-yield” savings accounts with interest rates that are closer to what we’re looking for with our emergency fund. Here we’re talking about interest rates in the .80% to 1.00% range (as of this writing, which is August 2020).

That’s still a low rate, of course, but it’s definitely better than .01%. And it’s light years better than having your emergency fund in your normal checking/debit account earning nothing at all, and you dipping into it in a non-emergency because it isn’t adequately separated from the money you normally use to live.

As far as emergency use goes here, you’re good–the money is already in cash, and you can get it transferred to your checking/debit account relatively quickly in most instances, as it’s simply cash moving from one bank account to another.

If you decide to go this route, compare rates across online banks and also check the fine print on the rates to see if there are any minimums or if the highest rate applies only to first X amount of dollars in the account.

Also be aware that in almost every instance of an online high-yield savings account, the bank will reserve the right to change the rate on you as they see fit. The rate you’re quoted is guaranteed, yes . . . until the bank changes it. They can, they do, and clearly they have, if .80% is considered “high-yield” (again, as of August 2020).

Still, are you earning more on your emergency fund here than in a checking/debit account or a traditional savings account? Yes indeed.

4. A money market fund in a brokerage account

Our final option is a way to invest your emergency fund that might return more than an online high-yield savings account, is still safe, and is still liquid. This way is through the purchase of a money market fund in a brokerage account.

At the risk of oversimplification (but appropriate for most of you at this point), let me summarize a money market fund for you like this: It’s pretty much the lowest-risk investment there is that is not a bank CD (certificate of deposit), a savings account at a bank, or a Treasury security (though money market funds can and do invest in CDs and Treasury securities). But it is an actual investment in a fund, and thus technically is not cash.

Now, that said, it is still liquid, because it is easily converted to cash. What’s going on when you have an emergency fund held in a brokerage account and invested in a money market fund is that you are taking on a small amount of risk to try to earn more than the yield of a high-yield savings account by investing in an actual fund.

There are two potential drawbacks here. First, you might earn more than a high-yield savings account, but you also might not. In most cases, you probably will over the long-term, which should be the timeline for your emergency fund (you’re going to have this emergency fund from now until retirement and beyond). Over the long-term, money market funds have, in general, earned more than high-yield savings accounts.

But remember that the higher return isn’t guaranteed because there really are no guarantees when any level of risk is involved. And with a money market fund, there is risk involved, even if it is only a small amount of risk.

The money market fund might not actually earn more. Or, in a rare and severe instance, the money market fund might result in a loss of some of your principal. As with any other investment, you cannot rely on past performance to predict future results with any certainty.

The second potential drawback is that there might be a slightly longer delay in getting your money out to use for an emergency when compared to a high-yield savings account. When you transfer money out of a money market fund, technically what happens is that your shares in the fund are sold for cash that can be transferred, and then said cash is transferred to your other account.

While this isn’t the place to get into the details of how money market funds work, you typically won’t think of a money market transfer as selling anything because money market funds always attempt to hold the net asset value (NAV) of the fund at a steady $1 per share (and very rarely do not succeed at doing so).

Your simple takeaway here regarding this second potential drawback is that because money market funds are more complex than a simple high-yield savings account, it sometimes might take slightly longer to get the money transferred to your checking/debit account. But it shouldn’t be a huge deal. We’re not talking a significant enough delay that would be a problem for most emergencies.

Again, the strongest appeal of a money market fund in a brokerage account as the place to hold your emergency fund is the potential of earning a higher return than a high-yield savings account, if you are willing to take a small amount of risk.

Taking everything in this post and summarizing it all, your two best options for your emergency fund are going to be either a high-yield savings account with an online bank or a money market fund in a brokerage account. Both account types are easily searchable online, if you’re interested, and either one will serve the purposes of your emergency fund well.

If you’re curious as to which route I go for my family’s emergency fund, our emergency fund is in a money market fund in a brokerage account at Vanguard because we are willing to take on the small risk of a money market fund in an attempt to earn more than what we would earn in a high-yield savings account. You’ll be hearing me say much more about Vanguard on this blog in posts to come, so please know up front that Vanguard pays me absolutely nothing for saying anything about them or recommending them.

You’ve already learned that an emergency fund is necessary. And you’ve learned what your emergency fund amount should be.

Now you know that, though an emergency fund is for when emergencies arise, you don’t want that money just sitting there doing nothing while you wait for a potential emergency. You want it working for you. And if you want it working for you, you’ve got to put it where it can.

A high-yield savings account or money market fund in a brokerage account are your two best options. The choice is yours.

Next time we’ll wrap up the emergency fund topic with frequently asked questions (FAQs) about emergency funds. See you there.