- I keep a six-month emergency fund on hand in a high-yield savings account.
- As a healthy, 20-something person, keeping that much savings around (instead of investing it) is not exactly logical I could earn a much higher rate of return by investing that cash.
- But in this case, I chose to make an emotional decision with my money because it helps me sleep better at night.
- See Business Insider's picks for the best high-yield savings account
I'm an analytical and logical person.
At least, that's how I think of myself. When I'm faced with a problem, I try to put emotions aside and use logic to find a solution.
After graduating from college, when I faced my first real personal finance problem, I tried my best to make a logical decision. However, emotions naturally crept into play.
The very basic problem I faced was how to best budget my money . I needed to decide if I should prioritize investing, paying down debt , or building up savings . I knew the logical thing to do was to invest as much as possible as early as possible, but I feared the unknown and prioritized saving.
Those savings would be for my first emergency fund .
First, what is an emergency fund?
An emergency fund consists of money you set aside to cover any unplanned expenses that might come your way.
Typically, the money set aside is liquid , meaning you could access it quickly if needed. A bank account is the most common type of liquid account.
Unplanned expenses are costs that are not in your typical monthly budget. They could be anything from a small auto repair bill to an unexpected medical expense.
Emergency funds are also used as a buffer to fund your lifestyle if you were to lose your job. A record number of Americans are faced with this challenge today, and having money set aside in an emergency fund is one thing that can help them get through it.
How I built my emergency fund
When I was first building my emergency fund , I looked at the two options in front of me:
- Build it over time
- Fund it all at once
Building your fund over time means balancing paying off debt, investing, and saving. For example, if you have $300 leftover every month after paying all necessary expenses, you might assign $100 to each of those goals, slowly building up your emergency fund over the span of a few months. Personally, this is the route that I took.
You could also fund your emergency savings all in one shot, but I would not recommend this option. If you put all your income towards an emergency fund instead of saving towards other goals, you could miss out on 401(k) benefits like employer matching, or face penalties on outstanding debt that you neglect.
I keep 6 months of expenses in my emergency fund
Most personal finance experts recommend keeping anywhere from three to 12 months' worth of expenses saved in an emergency fund. Where you land on that spectrum depends on a lot of factors, including your health, your likelihood of losing a job, and your overall risk tolerance.
I am a fairly conservative person, but also have a relatively low probability of needing to use my emergency fund. So I landed right in the middle at six months.
For me, this was a comfortable amount of money to stow aside.
Logic vs. emotion
Having an emergency fund probably sounds like a logical thing to do. You're preparing, and preparing is a logical move nine times out of 10.
This is the one time out of 10, though.
The rarely cited issue with preparing an emergency fund is the opportunity cost that comes with it.
I choose to keep my emergency fund in a high-yield savings account . In normal times, a high-yield savings account could return about 2% in annual interest, although right now rates are down. The interest helps protect my money against inflation, at least partly.
The alternative to using a high-yield savings account, or the opportunity cost, is investing the money. Bonds and bond funds can return anywhere from 2-3% annually. Better yet, equity index funds return about 7% per year on average.
For me, a relatively healthy person in my 20s, the logical thing to do with an emergency fund is to not have one. The probability of me needing an emergency fund is low, and the opportunity cost of not investing my money is high.
But having an emergency fund helps me sleep at night.
Having that money set aside is a type of insurance. For most people, myself included, the opportunity cost of keeping money on the sidelines is well worth the peace of mind that you can take care of yourself or your family during an emergency.
At the end of the day, this was one money problem where emotions beat logic for me.
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