Emergency Funds: Invest Or Save?

It is generally not a good idea to invest your emergency fund. While investing your emergency fund may cause it to grow faster, you run the risk of losing your initial investment if the value of your assets falls. This could leave you with less money to cover unexpected expenses. It is also difficult to access your money when it is tied up in investments, and you may have to pay withdrawal fees. Instead, it is recommended to keep your emergency fund in a savings account, which will preserve your initial deposit and ensure quick access to your money when you need it.

Investing your emergency fund: a bad idea?

An emergency fund is a crucial part of financial planning. It is a pool of cash that can help you navigate unexpected financial situations, such as unemployment, a drop in income, medical bills, or home appliance repairs. While it is wise to have such a fund, the question arises: should you invest it to potentially grow your balance?

Potential Loss of Money

Investing in the stock market or other volatile assets could lead to potential losses. When you invest your emergency fund, you risk losing your initial investment if the value of your assets decreases. In contrast, keeping your emergency fund in a savings account preserves your deposit, ensuring you have the full amount when needed.

Tax Consequences

When investing money in a taxable brokerage account, you will be liable for taxes when selling shares and realising gains. The tax rate depends on how long you held the shares. Short-term capital gains tax, usually similar to your regular income tax rate, applies to profits from assets held for a year or less. On the other hand, long-term capital gains tax, ranging from 0% to 20%, applies to assets held for over a year.

Difficulty Accessing Funds

Some investment options, such as retirement funds, are known for their difficulty in accessing funds. Depending on the plan, it could take several weeks to receive your money, and there may be additional financial penalties. Even low-risk investments like certificates of deposit (CDs) tie up your funds until the term ends, and early withdrawal typically incurs a fee.

Focus on Other Financial Priorities

For many, diligently saving for an emergency fund means forgoing other financial obligations and debts. Before saving for emergencies, it is crucial to do the math and ensure that other financial priorities are not neglected. If you have credit card debt or student loans, focus on paying those down first.

Alternative Options

Instead of investing your emergency fund, consider high-yield savings accounts, money market accounts, or CDs. These options offer liquidity, allowing you to withdraw funds quickly in an emergency. High-yield savings accounts and money market accounts often provide competitive interest rates, helping your emergency fund grow without additional risk.

In conclusion, while investing your emergency fund may seem tempting, it is generally not advisable due to the potential risks involved. Focus on keeping your emergency fund in liquid, easily accessible accounts, and explore alternative investment options for any surplus funds you may have.

Where to keep your emergency fund

It is recommended that you keep your emergency fund in a savings account, separate from your daily bank account, so you are not tempted to spend it. A high-yield savings account is a good option as it is federally insured, lets your money earn interest, and allows you to access your cash quickly.

If you are unable to open a savings account, you can consider a second chance checking account, which can help you build a positive banking history.

• Money market account: This is an interest-yielding account that offers higher-than-average annual percentage yields (APYs). Money market accounts usually come with a debit card or checkbook, making it easier to access your money.
• Certificate of deposit (CD): While a CD is not ideal for your entire emergency fund, you can use it for a portion of your savings. CDs offer strong interest rates and allow your money to grow until the account matures. However, withdrawing money before the term ends usually results in an early withdrawal fee.
• Prepaid card: A prepaid card is not connected to a bank or credit union, and you can only spend the amount loaded on it.
• Cash: You can keep cash on hand for emergencies, either in your home or with a trusted family member or friend. However, cash can be stolen, lost, or destroyed.

It is important to note that your emergency fund should be easily accessible and provide liquidity. While investing your emergency fund may seem tempting, it is generally not recommended as you run the risk of losing money and sacrificing liquidity.

How much should you save?

How much you should save for your emergency fund depends on your financial situation and goals. A common recommendation is to save enough to cover three to six months' worth of living expenses. This ensures that you have a buffer in case of unexpected costs, such as medical bills, car repairs, or a loss of income.

If you're just starting out, aim for a smaller amount, such as $500, and gradually work your way up. To determine how much you should save, consider the most common types of unexpected expenses you've had in the past and how much they cost.

It's important to prioritize building an emergency fund, especially if you have credit card debt or student loan debt. Focus on saving enough to cover your essential expenses for a few months, and then you can direct your attention to paying off any high-interest debt.

Once you've saved enough for your emergency fund, you can consider investing any additional money to grow your wealth. However, it's generally not advisable to invest your emergency fund in stocks or other volatile assets, as you may be forced to sell at a loss if you need the money unexpectedly.

How to save for emergencies

Saving for emergencies is an important part of financial planning. Here are some steps to help you save effectively for unexpected expenses:

Determine How Much to Save:

Financial experts generally recommend saving three to six months' worth of living expenses for emergencies. This amount can vary depending on your financial situation, so assess your essential monthly costs and aim to gradually build up your savings over time.

Choose an Appropriate Savings Account:

Select a savings account that is separate from your daily spending account to reduce the temptation of dipping into your emergency funds. Look for accounts with high-interest rates, such as high-yield savings accounts, to maximize the growth of your savings. Ensure the account is easily accessible so you can quickly withdraw funds in an emergency.

Set Up Automatic Contributions:

Making savings automatic is a great way to build your emergency fund without having to remember to transfer funds manually. Set up recurring transfers from your checking account to your savings account. If your employer offers direct deposit, you can also ask them to divide your paycheck between your checking and savings accounts.

Take Advantage of One-Time Opportunities:

Look for opportunities throughout the year to boost your emergency savings. For example, consider saving a portion of your tax refund or any cash gifts received during holidays or birthdays.

Avoid Investing in Risky Assets:

While it may be tempting to invest your emergency fund to maximize returns, it's generally not advisable to invest in volatile assets like stocks or the stock market. Instead, opt for lower-risk, liquid investments that allow you to access your funds quickly without incurring penalties.

Monitor Your Progress:

Regularly check your savings progress to stay motivated. Set specific goals and celebrate your achievements along the way. This will help you stay committed to your savings plan.

Remember, the key to saving for emergencies is to prioritize accessibility, liquidity, and stability over high-risk investments. By following these steps, you'll be well on your way to building a solid emergency fund.

What is an emergency fund?

An emergency fund is a pool of money set aside for unexpected expenses or financial emergencies. It is a safety net to help you through unforeseen events, such as periods of unemployment, a drop in income, or large, unexpected costs.

The purpose of an emergency fund is to ensure you have financial options when the unexpected happens. Without savings, even a minor financial shock could set you back, and you may be forced to rely on credit cards or loans, which can lead to debt. An emergency fund allows you to borrow from yourself, interest-free, and gives you the freedom to choose how to cover the cost of an emergency.

The general rule of thumb is to save enough to cover three to six months' worth of living expenses. This will provide a buffer to cover most emergencies, such as home or car repairs, medical bills, or a period of unemployment.

It is recommended to keep your emergency fund in a savings account, separate from your everyday bank account, to ensure it is easily accessible but not too tempting to dip into. A high-yield savings account is a good option, as it allows your money to grow with interest while remaining liquid.

While it may be tempting to invest your emergency fund to make it grow faster, this is generally not advised. Investing your emergency fund in the stock market or other high-risk ventures exposes you to potential losses and may make it difficult to access your money when you need it. It is better to preserve your initial deposit so that you have peace of mind during stressful times.

Frequently asked questions