What Does An Emergency Fund Cover And Where To Keep It?

Hello Neighbors,

I received a message after last month’s column on emergency funds asking what specific expenses should be included in an emergency fund. A bare-bones emergency fund should include only the cost of absolute essentials, also known as non-discretionary costs. These costs include rent/mortgage, modest estimated grocery expenses, utilities costs, gasoline, car and health insurance, medication costs, minimum payments on credit accounts, and other costs that you cannot legally, contractually, or physically go without paying.

To find an amount to include for utilities, you can either average your monthly costs across the last year or pick the highest amount you paid in a single month in the last year; this information should be accessible via your utilities account platform.

What is not included in the emergency fund are discretionary costs. These discretionary costs include subscription services such as Netflix, eating out or meal delivery services like GrubHub, cosmetics, alcohol, premium brand groceries and purchases, entertainment such as concert tickets, Amazon purchases (unless they include medication or essential groceries), as well as other expenses that you are not legally required to pay and which are not required for your health.

By keeping an emergency fund limited to non-discretionary spending, it lowers the bar for fully funding one.

Now that we have a good feel for what is included in an emergency fund, let’s discuss where you should keep these funds.

Placing emergency funds in a standard savings account preserves the literal dollar amount, but inflation — generally around 2% annually in the U.S. — erodes your spending power. Below, I will discuss options that protect against inflation and may actually make you money.

The gold standard for beating inflation in an accessible, safe, and liquid instrument is the high-yield savings account (HYSA). Traditional savings accounts offer interest rates from 0.01%-0.10% APY, which is significantly lower than the inflation rate. HYSAs, on the other hand, offer much higher interest; as of this writing, NerdWallet lists popular HYSAs ranging from 3.2%-4.3%. Since internet banks offering HYSAs lack the overhead of physical locations, they pass savings to customers via higher interest rates. These banks are still FDIC insured up to $250,000, and being separate from your checking account adds a protective layer against accessing funds outside of an emergency.

The next option is the no-penalty, or liquid, certificate of deposit (CD). Unlike traditional CDs, which require you to lock into a term and pay a penalty for early withdrawal, no-penalty CDs allow you to withdraw funds without penalty. The catch is that usually you must withdraw the entire amount if needed early, and you often need to wait at least seven days after opening.

NerdWallet also provides a dashboard of current no-penalty CDs, currently ranging from 2.5%-4.07%. These instruments are also FDIC insured in the case of bank failure. While no-penalty CDs do offer interest rates above inflation, they may have more restrictions than a HYSA — such as high minimum deposits — so they may not be for everyone.

The final option I will discuss is the money market account. These accounts blend the characteristics of a checking account and a HYSA. They often provide check-writing and debit card capabilities along with much higher interest rates than most standard checking or savings accounts. Current rates range from 3.5%-4.0%. These accounts are FDIC insured as well.

While money market accounts may be a good fit for some, similar to CDs they may require higher minimum deposits. Additionally, the ability to use these accounts like a checking account may weaken the separation of your emergency funds from funds for everyday use.

Inflation can erode the purchasing power of your emergency funds, which can result in your funds not being able to cover all budgeted expenses when an emergency arises. Placing your emergency savings in an account that is both separate from your checking and which earns higher interest can protect against inflation and may even earn you money.

If you have any questions related to personal finance or suggestions for topics you would like this column to explore, feel free to email me at masonmoneysolutions@gmail.com.

Currently Reading: “The Little Book of Common Sense Investing” by John C. Bogle

Andrew Mason, MBA, AFC Candidate

Disclaimer: This column is for educational purposes only and does not constitute financial advice.