The 5 Ws and 2 Hs of an Emergency Fund

July 19, 2021

The process of building an emergency fund can be considered the training wheels of personal finance. Since it’s the first step to becoming financially savvy, let’s use an educator’s interrogative grid to nail down the fundamentals.

Who? Answer: YOU. You should have an emergency fund. Whether you are old or young, retired or still working, a seasoned or amateur investor, everyone should have one.

Why? It protects you from having to go into debt when life throws you a curveball. Jobs are lost. Vehicles break down. Medical problems seemingly arise out of nowhere. When these kinds of events occur, you can run to your fund instead of giving into the allurements of the credit card. The “whys” don’t have to all be reactive though. Emergency funds can help prepare you to proactively not “stay stuck” and give you a pathway to switching careers or moving to a new place.

What? This is not an investment account. Boredom is the goal. Normally the money should be earning interest in an FDIC insured account or money market. I know, nowadays, interest is practically nothing, but emergency money should be risk-free money. Avoid investment risk and avoid terms that have penalties for withdrawal. Remember the reason for an emergency fund is so that the money is there when you need it and not at a value less than what you started with.

Where? Not in your checking account, that’s for sure. A savings account will do. The key is to make it easy—but not too easy—to access. Therefore, you might consider putting it in a savings account at a different bank as a psychological buffer. This helps you think twice before pushing the button to transfer it into your checking.

When? NOW. If you don’t have one, don’t wait another minute to start one. Go to your local bank or look for an online one. You could start setting one up faster than reading this blog post.

How? There are two of these Hs: how should I build this fund and how much should I put in it?

The answer to the first question is: set an automatic withdrawal amount each month. Whether is $50 or $5,000 dollars this should automatically be set up monthly. If you make it manual, human nature will kick in and suddenly months will slide by without the account accumulating.

The second question has a bit more debatable answer. Three to six months of expenses seems to be the standard. Some even say a year’s worth. I say, start with one month and build from there. But if you’ve built past a year or two into multiple years, you’ve likely moved away from an emergency fund into an End of the World fund. The error of this is that your fear of risk is now munching away at your fund’s value by the stealthy inflation monster.

We all need to rehearse the basics. Maybe this is what gets you started. It could also be your emergency fund is too big and now it’s time to start investing or that your investments are too risk-on and your emergency monies aren’t as big as they should be. No matter where you on this spectrum, take a minute to revisit your financial safety net.