Three Critical Things You Need to Know About Emergency Funds

Woman at a bank windowEveryone talks about how important it is to have an emergency fund, but few people talk about what kind of emergency fund that should be.

After all, there's a big difference between stuffing money in a shoe box for a rainy day and setting up a savings account. Take it up a level, and there's a big difference between letting your money hang out in a standard savings account and investing in a no-penalty CD or money market account.So if you're wondering exactly where you should put those emergency funds, here are some thoughts to consider:

You Want to Make Sure Your Money Is Accessible

We'll start with the obvious. This is an emergency fund, so while you may want your money to earn a little interest, little is the critical word here.

"Because of the need for accessibility, it will probably be difficult to find an investment that yields more than a fairly low return, since the trade-off for a higher return is normally risk, and an emergency fund should be kept in a vehicle that's free from risk," says Susan E. S. Howe, a Philadelphia-based CPA and a member of the National CPA Financial Literacy Commission (as are all the CPAs interviewed in this article).

How Much Money Should Be in That Emergency Fund?

"As a rule of thumb," says Howe, "it makes sense to have an emergency fund that will cover at least three months of basic expenses in case of a loss of income. For those who want more of a cushion, an option may be to divide the emergency fund into a very short-term supply of funds and a slightly longer-term part."

That way, says Howe, the longer-term part could be used for an investment with a little risk -- like a certificate of deposit that has a light penalty for early withdrawal.

But let's get a little real for some folks out there. Obviously, not everyone has money to cover three months' of expenses laying around to put into a savings account. So it may take you awhile to get there, but that should be your goal. And at first, if you can only put a little money away here and there, it may make sense to begin with the proverbial shoebox -- a second checking account (as long as there isn't a fee involved for maintaining a small balance).

After you begin to save up some serious money -- probably somewhere between two weeks and two months of expenses -- then you should start thinking of a place to keep your money where it can start collecting some interest.

Understand the Difference Between the Various Types of Interest-Bearing Accounts

You could go with a checking account that earns interest, or a no-penalty CD or an online high-yield savings account, says Alex Matjanec, a spokesman for MyBankTracker, a bank comparison website that has discussed this topic and numerous banking issues.

Matjanec says that some of the best savings accounts for emergency funds that MyBankTracker has found include Ally Bank and Incredible Bank (which has a lot to live up for, with a name like that).

Ally Bank offers a no-penalty CD at a rate of 1.20%, and Incredible Bank's interest-bearing checking account currently offers an interest rate of 1.35%. These interest rates won't make you rich, of course, but interest rates are painfully low these days, and the idea is that you might as well make something on your emergency fund.

Another option to consider, says Jimmy Williamson, a CPA in Albertville, Ala., is a money market deposit account. "They're basically savings accounts where the bank has greater discretion in terms of what it can invest in," Williamson says. "In return for this greater flexibility, the banks will often give you higher interest rates but may demand that you give them at least seven days' notice before withdrawals."

So a money market account isn't the best choice if you're struggling and can barely keep a balance in an emergency fund before suddenly finding you're withdrawing the money again. But if you've achieved that three months of savings and you're on a savings hot streak, you may want to move some of your money into a money market account.

Just don't put everything into a money market account and create a true emergency: You need to immediately get your hands on your pile of cash but can't access it for a week without paying a steep penalty. An emergency fund, as Williamson says, "needs to be put in a safe vehicle for possible immediate access."

Whatever you do, don't use the "unused available credit" on your credit card as your emergency fund, pleads Sharon Lechter, a CPA in Phoenix, Ariz. By doing that, She points out, you're not creating that nest egg for your future, and what's more, you can't even depend on it.

"This is a dangerous game to play given that many credit lines have been disappearing," Lechter says.

One last piece of advice: Keep pouring money into your fund, at least until you're sleeping well at night, if not longer. While an account that makes you a little extra money is a nice bonus, says Lechter, "the level of interest you're earning is not nearly as important as having the emergency funds put aside in the first place."

Geoff Williams is a regular contributor to WalletPop. He is also the co-author of the book Living Well with Bad Credit.
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