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Treat Your Emergency Fund Like an Insurance Policy

By Erik Folgate

Now that many of my friends and family know that I write for a personal finance blog, they tend to ask me more questions about personal finance. I always tell them that I’m not an expert at this point. I don’t have enough experience to call myself an expert. But, writing this blog and my passion for helping people learn what I have learned is what distinguishes me from the average individual. I’ve gained quite a bit of knowledge from doing research for this blog, reading books, and thinking beyond the box about personal finance. My philosophy about personal finance is that there is an emotional element and a mathematical element to it. Some personal finance bloggers focus more on the mathematical side and others focus on the emotional side. I think that a healthy balance of these two elements is essential to winning with your money.

One question that I hear popping up in the thoughts of you all is, “Where should I park my emergency fund when I’m not using it?”

Before I answer this question with my opinion, I want to back up one step before you have this question. First, ask yourself, “How am I going to treat my emergency fund?”

I submit to you that you should treat your emergency fund like an insurance policy, not an investment. Many of the mathematical minds immediately think about how they can maximize their returns on their emergency fund when they aren’t using it. You should never sacrifice liquidity to gain more return on your emergency fund money. The most ideal situation is to find a money market account that is easy to access AND gives you enough of a return to at least keep up with inflation. About two years ago, online savings accounts have great returns as high as 6 percent! But, since the recent changes by the Fed with certain interest rates, the savings account rates have gone down a bit. Still, I believe these are the best options for where to park your emergency fund, unless you emergency fund is big enough to get good rates at a traditional bank’s money market account. Usually you need $25k or more to get a decent rate. Your emergency fund is an insurance policy. It’s there to use when you’re in a bind, and you have a completely unexpected expense such as the water heater in your house breaking or paying a collision deductible for a car accident. Don’t treat it like it’s this investment money where you need to maximize its returns. It’s great if you can earn a little bit on it while it’s sitting there, but the most important thing is that you can have access to it quickly without paying any penalties to get it (i.e. putting it in a certificate of deposit would be a VERY bad idea).

How much should my emergency fund be?

If you’re trying to get out of debt (except the house) and you own a house, I would build up $1,500 to $2,500 for a baby emergency fund while your paying off debt. If you don’t own a home, you can probably get away with $1,000 as your fund. If you’re debt free except for the house, then I would save up 3 to 6 months worth of expenses. Remember, this is not 3 to 6 months of income, it’s how much you pay to live each month. If you want to build up a bigger fund than that, by all means, go ahead. This is a recommended minimum guideline. So, if you spend $2,000 a month on housing, food, utilities, and gas, then a $6,000 to $12,000 emergency fund is adequate.

So in conclusion, make sure that you check yourself and how you treat your emergency fund before you start thinking about what to do with it when you aren’t using it. It’s an insurance policy from the company of YOU. Self insurance is always the best insurance policy, because YOU are the claims adjuster.

Erik Folgate
Erik and his wife, Lindzee, live in Orlando, Florida with a baby boy on the way. Erik works as an account manager for a marketing company, and considers counseling friends, family and the readers of Money Crashers his personal ministry to others. Erik became passionate about personal finance and helping others make wise financial decisions after racking up over $20k in credit card and student loan debt within the first two years of college.

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Comments

  • http://www.creditwithdrawal.com Randall at CreditWithdrawal

    What with the Fed reducing the prime rate and most banks following lock-step with their OWN interest rates, it’s hard to find any place that pays hardly anything for parking your money at.

    Even a lot of money market accounts aren’t paying more than 4% or so.

    :(

  • Cheufong

    I agree with you!
    Emergency fund is just that – emergency funds, much like insurance policies. Returns doesn’t matter, liquidity is what counts.
    Only thing is, I feel that regardless of whether or not you own a home, a healthy emergency fund size should be about 3 to 6 months of expenses. If I don’t own a home, I’d probably still have to factor in rent.
    However having an emergency fund doesn’t mean that insurance policies are not redundant. It’s still handy for major disasters like a total loss of ability to work at all.

    • NG

      He just meant that if you own a home you’ll need a bigger fund because you would have to replace anything that broke ( A/C, water heater etc…). Now as a renter, anything that goes wrong would have to be replaced by landlord.

  • author

    Yes, you are right. It’s NEVER a replacement for other insurances, unless you are wealthy enough to self-insure your home, but you’re never wealthy enough to insure liability against yourself. Great comment.

  • dennyc

    I treat my emergency fund like a line of credit and any money I use becomes a debt, just like a credit card charge. In addition to any money paid back, I also add money to my “credit line” each month so it is constantly growing. It is much easier to be your own banker.

  • Clay

    Solid post. I am an insurance agent and a Financial Peace graduate/coordinator and was recently emancipated from my own student debts (I am also from Orlando, so the similarities just seem to keep piling on). I discovered your blog as I was searching for alternatives to my current emergency fund parking spot: bank Money Market @0.02% apr. While many short-term bond mutual funds have never had a negative return (and are thus a tempting alternative), your article reminded me that liquidity is a non-negotiable for these funds.

    My employer frequently recommends putting half of the emergency fund in a highly liquid account (money market or savings account) and the remaining half in a conservative fund (typically with a liquidity period of 3 to 5 business days).

    While we are thinking about emergency funds as insurance policies, we ought to consider the regular contributions to be made (similar to premiums) for increases in living expenses and inflation. Instead of taking on risk to earn interest, perhaps contributing a “premium” of 5% each year would be more in line with the emergency fund’s purpose.

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