What is the best way to manage your emergency funds? How much do you really need in your emergency fund?
Where to keep emergency funds for higher returns?
Boss Man Jax keeps his emergency funds in multiple online savings accounts. Although you do get higher interest rates than your typical banks, the online savings rates are still relatively low (about 2% in 2018) but our return is higher. Why multiple accounts and how do we get higher returns?
Simple. We open new accounts almost annually when there are “sign-up bonuses” being offered with banks that pay higher than average interest rates. Basically, we bounce our emergency funds around on a regular basis to collect sign-up bonuses which increase our return on those funds.
For example, Barclay’s Online Savings pays about 1.9% interest right now (2018); they paid us a new account sign-up bonus when we opened the account in 2016. I believe the bonus was $500 at the time but required a significant deposit. We get about the same interest rate at Discover Online Savings; they too paid us a new account sign-up bonus ($200 bonus). Note you don’t need to keep your emergency funds in the account all that long to get the sign-up bonus; usually 1-3 months at most.
Example: Discover Online Savings Bonus
- Sign-up bonus was $200 (required $20,000 deposit last year, now it is $25,000; $150 bonus for $15,000 deposit); 1 percent return in one month; your annualized return is higher than 1%
- Interest rate is ~ 1.9 percent (2018)
- Total return: greater than 3% on an annual basis; remember, we only needed to keep the money in the account for one month or so at that time and our annualized return is, therefore, higher than 3% (it is ~3% if you keep the money in the account for one year, which is not necessary)
In essence, you can practically double your return on your emergency funds using this strategy. An investment adviser recently told me to put money into a low risk real estate related fund paying about 4%. I reviewed the funds strategy, and it appears to be a good fund and good advice for some of our cash. However, although it is low risk there is still risk involved when buying the fund given it can go down in share price. Without any risk, we are getting almost the same return with online savings accounts. It is important to note this strategy involves a limited amount of money overall. If your emergency fund is say, $15,000 to $25,000, it can work out well for you. In addition, it took about an hour to setup the new account and transfer funds. One way to look at it is the return for my time: $200/hour.
How much should you keep in your emergency funds account?
You’ll find numerous recommendations and they are all over the place. Vanguard states that,
Most experts believe you should have enough money in your emergency fund to cover at least 3 to 6 months’ worth of living expenses. . . Start by estimating your costs for critical expenses, such as: housing, food, health care (including insurance), utilities, transportation, personal expenses, and debt.
You don’t need to include expenses for anything you’d cut from your budget in the event of a job loss or major catastrophe. For example: entertainment, dining out, nonessential shopping, vacations, savings for a second home, college, or other goals.(SOURCE: Vanguard, What’s the right emergency fund amount?)
Suze Orman fans hear 8 times your monthly expenses, but I believe that recommendation is incomplete and inaccurate for most folks.
Fact is, I believe the amount varies by individual, your recurring income streams (if any), your leisure-related expenses (vacations, cable, phone, nonessential spending, etc.), and your total net worth. In a true emergency, we still have income from recurring income streams such as rental property, recurring business income, interest income, affiliate programs, and investment income. Therefore, our emergency fund requirement can be less than others with similar expenses. Also, our current savings rate is a significant percentage of our total income. In an emergency, we wouldn’t be saving as much and we can immediately reduce that portion of our current income requirement.
If you don’t have any recurring revenue and you are basing your expense needs on “critical expenses” only, it is likely best to error on the high side of 3 to 6 months of emergency funds.
What we learned over the years:
- Emergency funds are extremely important – sooner or later you’ll need to access the funds (car repairs, new refrigerator, water heater, medical emergency, etc.).
- Cutting wasteful spending to increase your “percentage of income saved monthly” reduces your need for an excessive emergency fund (you’re already spending less money than you make and in a way you are accustomed to a lower income level).
- Building wealth over time allows you to worry less about your emergency funds given you’ll likely have multiple income streams. When you establish multiple income streams, you’ll need less money overall in your emergency funds account.
- Paying off debt is a high priority for everyone interested in financial independence. Establishing excellent credit is also key. It gives you more options and access to lower interest credit in an extreme emergency. In addition, you can make money from credit card companies like Boss Man Jax once you establish good credit.
OK, the logic doesn’t totally add up. Your expenses are your expenses right? How you estimate your expenses matters. If you use your “bare bones expenses” to calculate your emergency fund needs, than having a few extra months of savings is likely prudent. If you are starting out, paying off debt, and living like a hermit (extreme savings through radical reduction in expenses), you’ll likely need to replace all of your income to survive six months without going into additional debt.
Boss Man Jax has room for cutting additional expenses because he enjoys a few of the finer things in life and he enjoys his financial freedom. He has focused on: paying off debt (other than a very low interest mortgage), establishing excellent credit, a significant savings rate (well above 20 percent of income), and creating multiple income streams.
It’s not all about the money all of the time. It is about attaining the freedom to make your own choices about work, family, relationships, travel and so on. It is knowing you’ll be less stressed and lead a happy life on your terms. Again, how you establish your emergency fund depends on your individual and/or family goals and your current money habits.
If you are retired, or about to retire, you might want to consider longer term income and cash planning.
Have a plan for any cash needed from your portfolio for the next two years. You never know when a market correction will occur, but you’ll be prepared with an “accessible” cash reserve. This tactic will allow you to avoid being forced to sell stocks during a downturn to meet your cash needs.
I came across Jenny’s blog, GOOD LIFE. BETTER., while researching for this post. Jenny provides additional insight into her experience with emergency funds and lessons learned (good read).