Where to Save Emergency Funds and What Matters Even More

A few months ago, we published a post about the basics of emergency funds, noting that setting aside a reserve of money (to cover three to six months of your non-discretionary expenses) in case of an emergency is a key component of personal finance. We advised that this money should be saved in a liquid investment, but some have raised the question of where, specifically, they might turn for this service.  So, we address that question below, along with the caveat that determining an appropriate amount to save in your emergency fund is an even more significant financial decision than where it is saved, especially in the current low interest environment.

Where to Save.  As we mentioned in our prior post, your emergency fund should be kept in a very liquid investment to provide for easy access without any penalty for withdrawals. Having a savings account at your local bank might be the easiest in terms of managing your accounts and transferring money from savings to checking account without delay, but other online-based savings vehicles will likely offer a higher interest rate. For example, national banks with local branches, such as Wells Fargo and Bank of America, offer between 0.01% and 0.05% in annual yield, and credit unions, such as Apple and Navy Federal, offer between 0.10% and 0.60%, depending on the type of account and amount held in it. In contrast, online-based savings accounts with Ally Bank, American Express, and Capital One 360 offer 0.99%, 0.90%, and 0.75% annual yield, respectively.

What Matters Even More.  Moving your emergency fund from a bank or credit union to an online savings vehicle could certainly make a noticeable difference in the annual interest you receive.  As seen in the chart to the left, it could result in an increase of $294 per year on a $30k emergency fund, and, as Mike and Glenn like to say, if you saw $294 lying on the street, you would probably bend down to pick it up.  However, an even more significant decision regarding emergency funds is how much to keep in reserve for that potential emergency.  We discussed some of the risks of not having enough money in your emergency fund in our prior post.  If faced with an unexpected event (job loss, illness, etc.) without an adequate emergency fund, you may be forced to borrow money using loans or credit cards, often paying exorbitant interest, or to withdraw money from retirement accounts, paying significant taxes and penalties.  Conversely, there is also a risk, or at least a significant opportunity cost, to holding too much money in an emergency fund.  Imagine, for example, a person earning $120k per year, who could safely cover 6 months of non-discretionary spending with $40k in an emergency fund but, given fears about the market, inattention to her accounts, or some other reason, has built up an emergency fund of $100k.  The surplus $60k, even with a (relatively generous) interest rate of 1%, would earn $600 for the year, as compared with $3,600 if the funds were invested in a balanced portfolio of stock and bond mutual funds (assuming a relatively conservative 7% annual return).

Choosing where to save your emergency fund could result in a few hundred dollars of additional savings each year, but purposefully choosing how much to save in your emergency fund could result in much bigger savings by ensuring that you have neither too little money, nor too much money, set aside in case of emergencies.