Arguably, the most boring investment, but also the most important, in the world is an investment in emergency savings. Scanning rates at local credit unions, if you find interest rates higher than 0.5%, you will have done a good job. There is no excitement in watching a $1,000 account earn a measly $5 bucks a year, or worse. The grass in my lawn grows faster than that, even in the winter. At the same time, that incredibly boring account is also one of the most important. Here’s why:
Why Emergency Savings are Important
Sometimes life is just unfair and throws us unexpected challenges. There is no better example of those unexpected challenges than the Coronavirus and the social distancing that has ensued, straining finances for both individuals and businesses. It could be anything that throws us a financial curve ball; hurricane damage, a health event, an unexpected income change, having to support a loved one, and the list goes on.
The simple fact is unless you live in a fairy-tale, you will have unexpected expenses. When life happens, you have a few options. You can meet the costs by utilizing debt through a loan or credit card. You can withdraw from your investments. Or you can pull from your emergency savings.
The average interest rate for a credit card balance is 16%. Personal loan rates are a little better, averaging 9.63% for a 24month loan. Either way, it is an expensive way to deal with an emergency. Even worse, once you are in the debt hole, it is often a lengthy and difficult effort to climb out.
You may think you can just use your investments if there is an emergency, but the “Coronacoaster” markets show us why that’s not a good idea. In Florida, shut-downs and business closures started in early to mid-March, leaving many out of work. At the same time, markets were in the midst of crashing off their February highs. Selling investments during this time would have locked in the losses of the downturn while missing out on the subsequent rebound.
I say emergency savings are one of the most important investments because it helps avoid those two common situations when the suddenly unexpected happens. Pulling from your emergency savings will prevent you from borrowing money in your time of need and help you avoid dipping into your investments during a crisis. By expecting the unexpected, and saving for it ahead of time, we can create a much better financial situation.
How Much to have in Emergency Savings?
If you made it this far in the article, hopefully, you're convinced. Emergency savings are important. How much you should have in savings is different for everyone. Typically, 3-6 months of expenses are recommended as a reserve. In addition to the monthly expenses, we recommend adding up your insurance deductibles and adding that to your base number. From there you should make some adjustments up or down based on your situation.
Using myself as a guinea pig, my need for emergency savings was pretty low right after I graduated from college. I had no one relying on me, I didn’t have much in the way of long-term debt, and I could easily adjust my lifestyle to match my income. I was in a situation where I could be on the low end of the emergency savings spectrum. Fast forward more years then I want to count, with an 11-year old son and a stay-at-home mom relying on me, I need a lot more in savings. Eventual life events, like my son becoming independent or my wife heading back to work, will lower my need. Think about things like who you support and who supports you, health, your comfort level, and hire-ability. From there adjust your target cash reserve up or down.
Where to put Emergency Savings?
You are looking for your emergency savings to be risk free and accessible whenever you need it. Even with interest rates ridiculously low right now, you will earn more in a savings account than you will in your coffee can. You also don’t have to worry about bugs and water damage like you would burying your savings 5 big steps directly east of the big oak tree. Vehicles like Certificates of Deposits (CD’s) may not be readily accessible without penalty. Vehicles like stocks and bonds, while available within a few days, are not risk-free. That leaves plain old boring savings accounts as the best option.
Planning for tomorrow but living for today is always a challenge. You probably have many goals that compete for each dollar you earn, and you must prioritize between them. It may seem daunting to save up many months of your living expenses but saving for emergencies should be one of the higher priority goals for most. It really is one of the most critical pieces for financial security.
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This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.