emergency fund
Money Talk

GUIDE: How To Set Up An Emergency Fund

Part of adulting is getting yourself out of unideal situations.

If you hang out around All The Wiser, you know that we’re all about investing for the long term.

Part of the journey toward financial independence is not touching your investment accounts – even if the stock market drops. However, there is such a thing as investment with a shorter timeline.

When we say shorter timeline, we don’t mean a financial goal you want to achieve next Tuesday. We’re talking a time horizon of a few years – five and under, let’s say. An example of an investment goal with a shorter timeline might be a vacation, or a new wardrobe.

While those are great goals (we could all use a new pair of shoes), one financial goal everyone needs is a Rainy Day Fund, aka an emergency fund.

In this article, we’re going to explain why you need emergency money, and how to set up an emergency fund with step-by-step directions.

We’ve also broken this guide up into chapters in case you want to jump around.

Chapter One: What Are Emergency Funds?

Chapter Two: An Investment=Your Best Emergency fund

Chapter Three: Setting up your emergency fund.

 

Let’s get our money on!

Chapter One: What Are Emergency Funds?

We’ve all been taught to create emergency funds, AKA “rainy day” funds. But what do we mean when we say emergency? The truth is, a day doesn’t have to get that rainy for a rainy day fund to come in handy. There are a lot of occasions that might make you tap into your stash, and not all of them are dire.

Unfortunately, part of adulting is getting yourself out of unideal situations. As baller as you may be, by virtue of being a living human you’re probably going to encounter one of these emergency instances in your lifetime.

A Major Appliance Breaks

When you moved in, everything worked: the fridge, the dishwasher, the air-conditioner. Now you’re really getting into cooking, and one ominous evening the dishwasher breaks. Maybe your landlord is unresponsive, or maybe you’re a homeowner and the problem’s on you. Either way, when major appliances go bust it’s a lot more inconvenient than you’d imagine.

Is this a life or death situation? No. Chances are you could exist without some of this stuff. But you probably really don’t want to, and with an emergency fund you don’t have to.

Your Pet Gets Sick

via GIPHY

Pets are wonderful, but they’re expensive. First of all, there are regular bills like food and vaccines. Second, pets can require the occasional emergency trip to the vet. Third, sometimes we have to run out of town last minute and need to pay for our pets to come with us or pay for a dog sitter/kennel. Fourth, there’s that weird ear-cleaning medicine your dog needs because he’s allergic to all the other options–

You know what? Pets might deserve an emergency fund of their own…

Surprise! We’re Having a Destination Wedding

Your best friend tells you they’re getting married… in the Dominican Republic! Let’s start off by saying that destination weddings can be fantastic. They’re the perfect excuse to take a day off work and squeeze in a little sightseeing. The downside is they’re expensive. Weddings in general can be pricy (you have to dress up, get a present, call an Uber after three glasses of Champagne), and destination weddings add the extra costs of plane tickets and accommodations.

Don’t skip out on the festivities. Make it rain.

via GIPHY

You Get A Parking Ticket

Hopefully, most of us won’t have any major legal troubles in our lifetime. But we can all expect to run through a red light (it was yellow, it was honestly yellow), or have some other irritating fee come up. Stuff like this should be pesky, not earth-shattering.

If you have an emergency fund, you won’t have to think twice about plonking down a couple hundred dollars toward something annoying like a parking ticket.

You Want To Quit Your Job

A lot of people advise creating emergency funds in case you lose your job. But what if you want to quit your job and you don’t have another one lined up? Searching for a job is a full time job, so it makes sense that you’d want some free time to dig around. Having an emergency fund can allow you the flexibility to take some time to choose your next dream job. Alternatively, maybe you want to just take a break! Or work for yourself. Whatever the case may be, an emergency fund will have your back.

Typical Emergencies

Of course, emergency money is also good for typical emergencies like unexpected medical expenses. But we assumed you knew that.

Convinced yet?

At this point, you may be thinking, “okay, I get it. I need an emergency fund. So I’ll set aside a savings account.” We’ll dispel that myth in the next chapter.

Chapter Two: An Investment=Your Best Emergency Fund

Emergency funds are where short investments work their magic.

You might be thinking, “wait, what? Emergency funds should be saving accounts – not investment accounts! What if I need that money?”

It’s true: the only real way to keep your money accessible and free from investment risk at all times is by stuffing it under your mattress or putting it in a checking/savings account. But here’s the issue.

The downside with savings accounts is also the upside: they’ll always contain nearly the same amount of cash you put into them.

The Problem With Savings Accounts

When it comes to high-interest savings account, high interest typically ain’t too high, with some of the more favorable options giving you less than a 1% return. Having cold hard cash lying around might seem like a good idea. But the truth is, if you leave too much cash in one of these savings accounts, you’re not really keeping it safe.

Ever heard the term use it or lose it? Like your muscles, if you don’t keep your money active, it becomes increasingly less useful.

That’s because inflation brings the value of money down. Inflation is the phenomenon that takes place when prices rise, while the purchasing power of money falls. From one year to the next, the same $100 cash might only be able to buy you $99 worth of stuff due to inflation.

That’s a theoretical example, but you get the gist.

You can see how much inflation there’s been over the last ten years with this graph:

Inflation rates from 2006-2016

Our suggestion to you? Keep a few months worth of that cash in a investment account.

Investing Combats Inflation

Investments are different from savings accounts in that instead of your money sitting around, it will be put to work. Investing your emergency fund can help counter the value your money would lose to inflation and then some.

You’ll probably want to at least have the ability to have access to your emergency fund within a few years. But when you invest, instead of sitting around doing nothing, your money can potentially earn more money through the power of compounding

We’ll explain how that works in a second, but safety first. You might be wondering if the stock market a safe place for your emergency money?

Here’s the thing with the stock market: it goes up, it goes down, but the general trend over the last hundred years has been that it rises over time. We don’t recommend trying to time the market or going stock-picking. However, if you invest passively on your own or with the help of a trusted financial advisor over the long term, you probably won’t have to worry when the stock market drops momentarily. You can read more about stock market drops and how to prepare for them in this article.

There’s always a risk that the market will be on a downswing when you need to access your money. However, the earlier you can begin creating your emergency fund, the less you have to worry about your money not having time to recover from market dips.

When you invest money, instead of sitting around it becomes active. Your cash “exercises” and, like a muscle, has the potential to grow by earning returns. As your money grows, your now larger emergency fund amount of money has the potential to earn even more returns. This can happen month after month. Over time, these returns can compound – combine – and help you earn more money than you originally put in.

Say it with us now: the power of compounding is astounding.

On the other hand, in a savings account, your money may be at risk for compound inflation.

What About Down Months?

We’ll be the first to say there are months you’ll likely “lose” money through investing – at least on paper (more on that later). Even with the “safest” of investments, risk is part of participating in the stock market. Consequently, you may not feel comfortable using an investment account for an emergency fund.

While you can certainly seek out financial planners that will create a portfolio to ease this worry (see: the next chapter), we understand that sometimes only cash will ease your fear. In this case, you’re welcome to keep several months-worth of expenses in a savings account.

But remember: simply leaving money in a savings account could allow it to lose more and more value over the years due to a combination of low interest rates and inflation. Therefore, a savings account should never be the be-all-end-all to achieve your financial goals.

When Should I Start Converting My Savings Into Investments?

Don’t kill us, but the answer is simply when you’re comfortable!

While investing is a long term game, keep in mind there are many different ways to invest, some more conservative than others.

But as we mentioned, if you’re absolutely sure you want to keep some cash liquid in a savings account, go for it. Just make sure you’re not going veering into savings overkill.

However, if you think you’re ready to set up an investment account for your emergency fund, we have your action plan handy.

Chapter Three: Setting Up Your Emergency Fund

The day has come, and you’re ready to set up your emergency fund. You’ve decided on a investment account because while you may need access to that money within the next few years, you’re comfortable letting your money grow in the meantime.

Here’s what to do.

One: Decide how much emergency money you need

How much money you want to put in your emergency fund is entirely up to you. A good baseline is of 3-6 months worth of living expenses. Keep in mind: expenses doesn’t mean income. Figure out how much you spend per month (more or less) and set that number as your target achievement.

Two: Open an investment account with ETFs.

We’re huge proponents of passive investing in index funds (you can read why here), so we recommend ETFs for every investing account. Broad-based index ETFs are a good option for emergency funds because they’re highly liquid. If you need access to your emergency money quickly, you can quickly sell your ETFs for cash. This efficiency is ideal when you’re creating an account like an emergency fund, which you’ll want to tap into in a pinch.

Opening an investment account is simple and complicated, because you have a lot of choices. There are thousands of place to open up investments accounts, and thousands more ETFs to choose from. Decide first if you want to manage your own investments or want help from a financial advisor.

Tip: Guide: What is a good investment?

There’s no right or wrong answer here. If you’re up for managing your own investments, Vangaurd is always a great place to start (we don’t get any points for saying this) because they don’t charge any commissions to buy their low cost mutual funds and ETFs. Check out their commonly purchased ETFs and assess which ones are good for your time horizon. Since your emergency fund is a investment you may need sooner rather than later, you may want to lean more heavily toward bond ETFs, which typically have lower returns but also lower risk of loss. You would purchase these ETFs directly from Vanguard.

If you’d prefer someone else took care of the portfolio management and rebalancing, opt for a financial advisor. But be wary, we’re not all created equal.

Your financial advisor should:

-Use passive investing, because actively trying to beat the market is really, really difficult
-Have low fees (management, trading, etc.)
Be a fiduciary (basically: is legally required to have your best interest at heart)

There are brick and mortar financial advisors and online financial advisors (like us). Their account minimums and fees vary, so make sure to do your research to find one that’s right for you.

Whether online or in person, your financial advisor should be able to create the right portfolio for your emergency fund based on your investing preferences, financial details, and time horizon.

After your emergency fund is set up, go on to step two.

Three: Begin contributing and automate your further investment contributions.

Once you have your target number, begin with an initial deposit you can manage, and automate your investment contributions moving forward. The more frequent your contributions, the more increased your dollar cost averaging becomes. So, contribute weekly, or monthly, to your investment account.

By automating your investments, you’re taking the guesswork out of the knowing whether or not you’ve contributed enough to your investments. You no longer have to wonder did I deposit enough money in my emergency fund? or will I have enough money to deposit into my emergency fund? By automating your investments at the beginning of the month, you have no choice but to contribute to your emergency fund.

Woohoo! Emergency Fund Complete

Once you set up your emergency fund, rejoice! Just because your emergency fund is complete doesn’t mean you have to go out and find an emergency to spend it on. Instead, by keeping your fully built up emergency fund invested, you can watch it grow without contributing a dime. You can now focus your attention on retirement or other achievement goals.

Check out these other guides to bulk up your investment knowledge:

The Benefits Of An IRA Maximum Contribution

What Is A Good Investment?

What To Do When The Stock Market Drops

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Aliza Kellerman Aliza Kellerman is the Manager of Content Strategy at WiseBanyan. When she's not writing about the life and times of the IRA, she's hanging out with her pug.