Let’s Talk About Optimizing Your Emergency Fund

Financial independence (FI) is not binary: achieving FI is a journey, and I believe that having an emergency fund is one step in that journey.

For those of us who want to invest every dollar, it might be tempting to try and go without an emergency fund. While I get that it is tempting to game this aspect of your personal finances, trust me, you still need one. This is the bedrock of your portfolio.

Remember: The whole reason we strive for financial independence is so we can buy our freedom from the problems and stress that money can bring into our lives.

As I have mentioned elsewhere on the blog:

Money is a tool. You can either use it to destroy or build, and an emergency fund is an important step in building.

An emergency fund is one of the first steps in using money as a tool to build your FIRE. For those of you starting on your path to FI, this will actually give you independence from some of the stress that an emergency situation could cause.

When an emergency happens, it is great to not have to also stress about going into debt or having to withdraw from another investment.

Ideally, once money goes into the market, it stays there until you achieve FIRE.

Think of it this way:

Since you are more likely to lose your job in a time of a recession or market crash, chances are high that the money in your index fund might be down in value due to the same reason you lost your job. Since withdrawing when your funds are low in value is pretty much the only guaranteed way to lose money in buy and hold investing, this compounds issues.

Another bonus is that having an emergency fund can give you the support and courage you need to have a higher amount of stocks in your asset allocation, as you would be less likely to need to dip into that money in the future. Since a higher stock allocation historically grows money faster, putting cash in an emergency fund may pay off more than putting that cash in the market for the long haul.

Common questions I hear about emergency funds are:

How many months of spending should I keep in my emergency fund?

While I think you should have an emergency fund, I am not a big fan of keeping a king’s ransom in there. I think that six months of living expenses is fine, but it is 100 percent up to your specific situation and you how much you feel comfortable setting aside. At a certain point (like keeping a year’s worth of expenses for instance) it begins to be too much money to not have working for you. Start with six months, see how you feel, and then go up from there.

How do I figure out how much money is one month of living expenses?

If you have not figured out how much money you spend in a month, stop and do that now and then come back to this post. Seriously. The first step towards building your FIRE is knowing that number. If you don’t know how much you spend and what you spend it on, you will never be able to control your savings rate.

Something to consider:

If you have some space in your budget where, in a pinch, you could cut down on unnecessary spending (entertainment, eating out, etc…) then you can just count what you would absolutely need to spend money on such as groceries, utilities, and other non-negotiable expenses.

Now that we have the basics covered, here are different ways (with pros/cons) that you can set up your emergency fund:

The Standby

This is what most people do, so I won’t talk about it too much, but there is nothing wrong with keeping your money in a standard savings account or money market account. If you pick this route make sure you shop around for banks with high interest as you want to come as close as possible to matching inflation each year your money sits there. The site Doctor of Credit has a super comprehensive list of high-interest savings accounts, including some offers that might only be available in your area.

Pros:

  • Easy to set up.
  • You can set it and forget it unless, of course, the account you pick has something that needs to be monitored (read that fine print, y’all!).

Cons:

  • Money doesn’t typically earn that much interest in a standard savings account, making the money worth less year after year due to inflation.

The Unorthodox Account

As of writing this post, the highest interest account that I could find is this 5% pre-paid card. While it is not a savings account by definition, there is nothing stopping you from essentially using it as one.

The big restriction here is that you can only contribute $5,000 to this card, but for a savings account chances are that this would be a significant portion of your fund. While you can only have one of these cards per person, there does not seem to be anything stopping a couple from getting one card each, which could put a significant chunk of your emergency fund into a 5% account!

Any remaining amount of your emergency fund would simply go into your high-interest accounts.

Pros:

  • That, sweet, sweet, 5% interest.

Cons:

  • You need to have one transaction a month to avoid a fee. You will need to set up a $1 automatic transfer from your bank account. This is a one time action.
  • You will need to be OK with the restrictions of the card’s unloading (which I think are reasonable) such as a $2,500 withdrawal limit per day and different unloading methods. As with any account, make sure you read everything prior to signing up.

The Gambler

Some people do keep their emergency fund in investments, but I think this is something that only someone with a sizable stash should even begin to consider. I do not recommend this option unless you are well on your path to FIRE, know what you are doing, and are comfortable with the risk.

If you do decide to do this, make sure you keep at least a month’s expenses in a savings or similar account. I would also recommend a conservative mix for the fund, no more than 40/60 stocks/bonds allocation.

Pros:

  • If you have this money invested for a long enough time, chances are that if you do need to withdraw it down the road you would be selling at a higher price than when you invested even during a down time for the market.

Cons:

  • You have the chance to lose money, as you could be put into a situation where you need to sell your assets at a lower price than what you initially bought them for.
  • Could add extra stress to a market downturn if your emergency fund dwindles while you worry about your income security.

Other options:

There are many other vehicles where you could keep your emergency fund and permutations for how much you should stash in each one. Here is a small list of other places to investigate if you are looking into optimizing your emergency fund and the options above do not work for you:

  1. Short term high-interest CDs
  2. Ginnie Mae bonds
  3. I-Bonds

What vehicles to your keep your emergency fund in? How many months of spending do you keep?

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4 thoughts on “Let’s Talk About Optimizing Your Emergency Fund

  1. Hello,
    I like your writing style a lot and this post was very good at explaining emergency funds. Can you explain i-bonds since I’m not sure what they are but I’ve heard them mentioned before.
    Thanks,
    Gavin

    1. Hi Gavin – I-bonds (or Series I-Bonds) are when you, in the form of purchasing a bond, lend money to the government.

      They then promise to grow that money with a fixed interest rate and protects it from variable inflation. This is all great, but you can’t liquidate the bond until you’ve held it for a year AND if you cash it before holding it for five years you forfeit the last three months of interest. You are also taxed in the interest when you sell. This would only be a good option for emergency funds if you wouldn’t need the money for 1-5 years.

      My mom had the family buy me i-bonds instead of birthday presents when I was a toddler. Actually just cashed them in and put it all in VTSAX!

  2. “Since you are more likely to lose your job in a time of a recession or market crash, chances are high that the money in your index fund might be down in value due to the same reason you lost your job.”

    This is a really sound reason for NOT keeping your emergency fund invested in the stock market. This is a great write-up and will help many people navigate through their finances and help build their financial IQ. Thanks for sharing!

    1. Thanks, Brian!

      Yeah, it’s not ideal to put your emergency fund in the market. Probably best to just keep it in a boring old savings account while you build up your FIRE stash.

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