Establishing an Emergency Savings Fund

INTRODUCTION

This article explains what an Emergency Savings Fund is, why it is important to establish and maintain an Emergency Savings Fund, how to calculate the amount needed in the Fund, and the types of investment vehicles best-suited for this type of Fund. 

KEY TERMS AND DEFINITIONS

1. Income Statement: a document which summarizes income, expenses and net cash flow for a past period (typically a month, 3 months or 12 months). Similar in structure to a budget, the income statement is based on income and expenses that have already occurred.
2. Essential Monthly Expenses: non-discretionary costs including rent/mortgage, utilities (electricity, water, internet, phone), groceries, insurance (health, car, home), existing debt payments (loans, credit cards), transportation (gas, public transit), child care and ongoing medical costs.
3. Non-essential Monthly Expenses: discretionary costs including dining out, entertainment, vacation travel, gifts, memberships, subscriptions, luxury goods and personal care services. These are often referred to as “wants”, whereas the essential items listed above are considered “needs”.
4. Budget: a spending plan defining projected income, expenses and net cash flow for an upcoming period. Similar in structure to an Income Statement, a budget is based on projections of future income and expenses.

WHAT IS AN EMERGENCY SAVINGS FUND USED FOR?

An Emergency Savings Fund is used to pay for unplanned expenses (i.e., expenses not included in your budget) or cover your essential expenses in case you experience a temporary loss of income. We establish an emergency fund to avoid having to leverage loans or credit card debt in such situations. Examples of situations that may lead to emergency fund use include:

1. A job loss or reduction in compensation,
2. Car or Home repairs,
3. Medical bills,
4. Emergency travel

HOW DO I CALCULATE HOW MUCH I NEED IN MY EMERGENCY FUND?

To start, we recommend creating an updated income statement and budget. Within the budget, separate the expenses that meet the “essential” criteria defined above and create a monthly total of these “essential” expenses.

The next step will take into account your work and life circumstances. In general, I suggest the guidelines noted below:

Using these guidelines, a single person with a stable job with essential monthly expenses of $3,000 will want to establish an Emergency Savings Fund with $12,000-$18,000 in assets.

HOW TO INVEST AN EMERGENCY FUND

Because the assets in an Emergency Savings Fund may be needed on extremely short notice, it is best to implement ultra-safe investments with minimal volatility or time commitment. 

We specifically recommend these investment types:

1. Money Market Mutual Funds: offered by investment companies such as Fidelity, Vanguard and Schwab, these accounts pay a significantly higher interest rate than traditional bank accounts and often offer features such as check writing, Bill Pay, etc..
2. High-yield Bank Savings accounts: often offered by online banks such as Ally and Marcus, these accounts pay a significantly higher interest rate than traditional banks. It is important to understand any account conditions such as duration of the initial interest rate, minimum balance required, and transaction restrictions.
3. Bank Money Market accounts: very similar to a Bank Savings account, these accounts often pay slightly higher interest rates than a savings account and include a debit card and/or check-writing privileges. Some bank money-market accounts may have limits on the # transactions per month and a minimum deposit amount.
4. Standard Bank Savings and Checking accounts: this is a simple option with no minimum investment amount and immediate access to the assets. The downside to these options is that most banks offer extremely low interest rates on savings and checking accounts.

We do NOT recommend CDs, stocks, mutual funds or ETFs for Emergency Savings Funds due to their volatility and restrictions to asset access.

SUGGESTIONS

1. Keep your Emergency Savings Fund separate from your day-to-day savings and checking accounts and other savings funds. This will help you earmark these funds strictly for emergencies and make it easier to track its balance vs. your target.
2. If 3-to-12 months of essential expenses seems overwhelming initially, start with a more modest Emergency Fund goal of $1,000. This will be enough to cover a lot of emergency expenses and can help build your confidence as you strive for the fully-funded goal.
3. Automate regular contributions until the Emergency Savings Fund value goal is met. Most Money Market mutual funds offer automated investment features to allow monthly purchases.

BOTTOM LINE

When you are faced with a financial emergency, it can threaten your financial well-being and cause stress. Being prepared with an emergency fund can allow you to deal with unexpected events without disrupting your overall financial plan.

REFERENCES

The articles below were referenced in preparing this information and are excellent resources to better understand this topic.

1. https://www.consumerfinance.gov/an-essential-guide-to-building-an-emergency-fund/.
2. https://investor.vanguard.com/investor-resources-education/emergency-fund. 
3. https://www.voya.com/page/steps-establish-emergency-fund. 
4. https://www.eustaceadvisors.com/blog/simple-way-make-your-savings-work-harder-you. 

This content was developed from sources believed to be providing accurate information. The information provided is not intended as tax or legal advice, and readers are encouraged to seek advice from their own tax or legal counsel. Neither the information presented, nor any opinion expressed, constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed by Eustace Advisors to provide information on a topic that may be of interest.