I consider an emergency fund to be an essential personal finance tool. Everyone needs to have some cash reserves for those unexpected moments so that you’re not living off of a credit card due to an unexpected unemployment or illness or automobile repair or emergency travel or any of a million other emergencies that can take us by storm.
(If you don’t have an emergency fund and would like to get started, I highly suggest reading this detailed guide to starting an emergency fund that I wrote a while back. It’s easier than you might think to get started!)
One of the most common questions people ask me is where to store their emergency fund.
When people look at the interest on savings accounts today – usually around 1% – they understandably feel underwhelmed when they see stocks returning 10% a year and reaching all-time highs. They think to themselves – again, understandably – that if they have this lump of cash sitting around, they should have it sitting somewhere where it can earn a better return than the 1%, and they usually eye the stock market.
Other people have other ideas. Maybe they should store it in their mattress. Maybe they should buy gold with it. Maybe they should have it in certificates of deposit at their banks.
I’m going to walk through some principles of a healthy emergency fund that should help you to eliminate some of these options and give you a healthy place for your emergency fund.
Principles of a Healthy Emergency Fund
It needs to be liquid.
In other words, you need to be able to actually convert it to cash in your hand extremely quickly.
This is why investments like real estate tend to be poor uses for an emergency fund. You can’t simply sell a property extremely quickly without taking a loss on it because that’s not how the real estate market works.
The king of liquidity is having cash in your hand. After that, having cash available at any ATM is pretty good. Almost everything else is less liquid. For example, stocks generally have to be sold, then cash has to be transferred away from your brokerage, which can take a few days. Gold or precious metals require you to have a broker who will buy it from you.
For this, cash and a savings account come out on top, real estate comes out near the bottom, but many other things are pretty solid.
It needs to have low volatility.
In other words, the value of the item shouldn’t vary much on a day-to-day basis.
Why is this important? Let’s say you buy enough gold at $2,000 an ounce so that you can cover one month of living expenses. Over the next three months, the price of gold drops to $1,400 per ounce. Suddenly, you have 30% less emergency fund than you thought and if an emergency strikes, you may not have nearly as much as you thought to cover it.
Gold and rare metals are very volatile. Stocks and real estate are rather volatile. Again, cash and savings accounts come out on top – they’re not very volatile at all.
It needs to be insured.
At this point, having cash in your mattress or in a savings account makes the most sense. However, the problem with cash in the mattress is that you wouldn’t be able to access it in the event of, say, a house fire. It’s just gone at that point – at the very point when you’d probably need it the most.
Having your cash in a savings account means two things. One, it’s still available in the event of a personal disaster. It’s also FDIC insured, meaning that in the event of a bank failure, you’d still retain up to $250,000 of the account’s balance.
Above all else, your emergency fund needs to be safe, reliable, and accessible.
After all, when you have an emergency, you want your emergency fund to be there for you as quickly and reliably as possible. Because of that, I almost always encourage people to forego the potential of larger returns and stick with a good savings account.
As for the other investments, I think they’re perfectly reasonable options for people who have achieved debt freedom (or merely have a very low interest mortgage remaining) and are fully funding their retirement. At that point, investment in things that are less liquid or more volatile can be a good decision. The important thing to remember is that such investment is different than an emergency fund because you’re not intending to ever use it outside of whatever personal goals you have for the money.