Emergency Funds

Why have an emergency fund?
One of the core components of a healthy financial plan is an emergency fund. Many financial experts even recommend the emergency fund be your first financial goal. I agree with this sentiment. But why exactly should you have an emergency fund?

The main goal of an emergency fund is to cover unplanned expenses (aka emergencies) that arise so that you don't have to go into debt to cover those expenses. In particular, there are several different common major emergencies an emergency fund can cover:

• Car repairs and car replacement
• Medical visits and emergencies
• House repairs such as flooding and fires (if your home insurance doesn't cover or doesn't pay out immediately)
• Loss of job, or a loss of income do to disability, pregnancy, or some other emergency
• Expenses associated with family emergencies and tragedies
• Many, many other events that cost nontrivial amounts of money

So how much should you save up?
Ask 10 different financial experts and you will get 10 different recommendations, of which the most common are:

• Based on a number of months of expenses, typically 1, 3, 7, or 8 months
• Specific amounts, such as $5,000 or $10,000
• One year of expenses
• Whatever you feel "comfortable" setting aside or whatever is right for you

Some experts, such as Dave Ramsey, recommend a combination of the above in a step wise manner. He recommends first saving up $1000 in your emergency fund, paying off debt, then saving up 3 - 6 months of expenses. I agree with Dave with his methodology of first starting an emergency fund, paying off debt, then finishing up the emergency fund. But I disagree with the amounts.

Rather than first saving up $1000, I recommend to first stop living paycheck to paycheck by saving up one half to one month of expenses. Once you have it saved up, then you should be able to cover situations such as minor car repairs, buying a beater car if your car needs to be replaced, a doctor visit, a loss of job or disability for up to one month, and expenses associated with family emergencies. Keep half of your money in your checking account and the other half in either a traditional or money market savings account. This will help cover some emergencies where you don't have time to transfer the money from the savings account to the checking account and will prevent you from over-drafting in such an event. It will also prevent you from over-drafting if the timing of paying your bills doesn't work out exactly as planned and a large bill is paid the day before payday.

After you have paid off your debt, save 3 months of expenses. The three months of expenses would be able to cover the estimated average out of pocket maximum towards medical expenses (1) before health insurance pays out, loss of job or disability for three months, and cover some substantial house repairs. At this point I recommend to start saving 10% of your income towards retirement.

But your emergency fund still isn't complete yet. Why? Because 3 months of expenses doesn't cover the average duration of unemployment. From 1948 until 2008, the average duration of unemployment was between 7 and 20 weeks (2). If you save up 6 months of expenses, then you should be able to cover all of your expenses long enough to get a new job. It will also help cover many major house repairs and cover your expenses up until long term disability insurance kicks in, which is usually around 6 months (3). Once you have set aside 6 months of expenses, your emergency fund is complete.

References:
(1) http://www.goinsurancerates.com/health-insurance/out-of-pocket-expenses-series-maximum-limits/
(2) http://economix.blogs.nytimes.com/2011/06/03/average-length-of-unemployment-at-all-time-high/
(3) http://employeebenefits.about.com/od/ancillaryinsurance/a/LTDBasics.htm

Types of Savings Accounts

There are many different types of savings accounts available at banks and credit unions, and it may be difficult keeping track of the advantages and disadvantages of each type of account. Here is a quick rundown of the basics to each type of account:

Traditional Savings Account - A simple account available at just about any bank or credit union intended to hold money you set aside for any number of reasons. These accounts tends to have the fewest, if any, limitations on balances, very low minimum balances requirements, but also pay the lowest interest rates.

Money Market Account - Similar to the traditional savings account, except the interest rate is tied to the interest rates of money markets, which is a part of the financial markets for short term lending. These accounts have a slightly higher interest rate than traditional savings accounts, but tend to have higher minimum balances requirements (in the 1000s), and a low limit on maximum transfers per month (3-6 usually). There is sometimes a delay when transferring money out of the account. They are also offered at most banks and credit unions.

High Yield Savings Account - A savings account with a high interest rate that is usually a money market account, so it has all of the same limitations as a money market account. In addition, there is nearly always a delay when withdrawing money from this account when not using checks. A few banks and credit unions have these accounts, but they are now mostly available at online banks. Many people choose not to use a high yield savings account because the money is not immediately available.

Certificate of Deposit (CD) - A deposit you make at the bank where you agree to leave the deposit at the bank or credit union for specified amount of time, which is also known as a maturity date. Once the money has stayed at the bank to the maturity date you are paid interest on the money and allows to pull the money out. The longer you agree to leave the money in, the higher the interest rate paid to you. If you choose to pull the deposit out of the bank prior to the maturity date, then you forfeit the interest and pay an early withdrawal penalty. In the past CDs had interest rates that were noticeably higher than other types of savings accounts, but nowadays pay about the same interest rate. Unless you know that you will not need the money for a long time, CD's usually are not work the risk of early withdrawal penalties.

Health Savings Account (HSA) - A special savings account intended to hold money set aside for medical expenses available to people who have a high deductible health insurance plan. HSAs are tax advantaged in the sense that deposits to the account can be made pre-tax, and withdrawals are not taxed as long as they are used for approved medical expenses. HSAs tend to pay about the same interest rate of a money market account, and some banks allow the money can be invested. There is a federally mandated limit on the amount that can be contributed to HSAs annually. If money is pulled out for non medical expenses, than there is a penalty of 10% plus the owner will be charged tax on what is withdrawn.

Purpose of Savings Accounts 

Many people set aside money for different purposes, ranging for saving up for anything from upcoming expenses (short term savings), to expenses that are several years away (long term savings). However, the most recommended is an emergency fund. An emergency fund is just as the name implies - money set aside for times when there is a financial emergency. For example, common emergencies include a lost job, paying for car repairs or a car replacement when a car breaks down, severe damage to a house, or paying for a medical emergency. Some people also set up sinking funds, which is money set aside over time to pay for expenses that will happen but the time of the expense is unknown.

I have recommendations for how to split up your savings accounts, and why you should split up savings accounts, here.

Advantages of Multiple Savings Accounts

Have you ever asked your self, "Where did the money I saved for... go?", or "Hmm, I can't tell how much money I set aside for ...?" Chances are you need multiple savings accounts.

Multiple savings accounts help you keep your money organized. Each account has its own balance and transaction history. This allows you to quickly, and clearly, see which money is set aside for which expense without have to dig through one monolithic transaction history of one account. They also provide an explicit barrier between your accounts. You are much less likely to accidentally spend money for one expense that you have set aside for another simply because the check or debit card you use simply wont affect the account that hold the other expense.

Multiple accounts also provide a layer of protection from thieves. If someone manages to get a hold of your debit card or checkbook for your checking account or one of your savings accounts, your money in the other savings accounts would be protected. The thief would not have immediate access to that money in the other accounts.

If your bank imposes transaction limits on your savings accounts, they may impose the limit on individual accounts rather than one transaction limit for all savings accounts. If so, setting up multiple accounts effectively multiplies the allows number of transactions you can make before you hit your transaction limit. In addition, some banks do not impose limits for transfers made between savings accounts online, making it easier for you to reassign money as you like. Check with your bank to find out their savings account transaction limit policies.

If you have been avoiding setting up multiple savings accounts because of the hassle factor, then you would be pleased to hear that creating new savings accounts are easier now than ever before to setup. Many banks now provide options to quickly setup additional savings accounts online without having to go through the effort of filling out paper work or driving to a branch. You could even choose an online bank so you never have to leave the house.

So how should the money be broken up?

At a minimum, put your emergency fund in a separate savings account. This guarantees that every time you take money out of the account it is intentional. This account would be a good choice as a high yield savings account since the balance should be relatively high and steady.

After you have setup your emergency fund account, the next step would be to split your savings into a short term savings account and a long term savings account. The short term account could hold expenses that usually take less than a year to save up and are relatively small expenses. For example, this account could hold things such as quarterly insurance premiums, money for Christmas gifts, or any other lump sum expense you plan to make throughout the year. The long term savings could hold things that take are major expenses, such as vacations, car replacement, furniture replacement, or down payments for house. Many people decide to go even further and breakup their long term savings into more accounts for specific goals to keep track of the balance for each goal.

Regardless of how you much you separate out your savings, the point is that you keep track of your savings. If it's easier for you to keep track of just one savings account, then have just one savings account. If keeping track of your savings in one or a few account, then split it out into more. Just know where your money has gone, where it is, and where it will go.