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A trip to the emergency room, car trouble, or a broken water heater can happen unexpectedly. They can also be expensive. An emergency fund can help you meet these obligations without you having to borrow money from the bank, friends, or your 401(k). More importantly, a rainy day fund can also help you meet your regular household expenses in the event you lose your income for any reason.

Planning for Emergencies

Emergency funds should be a component of your long-term financial plan, but they shouldn’t be viewed as investments. Before you begin an investment program it makes sense to have sufficient cash saved for short-term needs and emergencies. Your emergency fund should hold enough money to cover six to 12 months of living expenses. It also needs to be stable.

Your emergency fund should not be subject to market fluctuation. Because it should be held in conservative vehicles, you can err on the side of caution here. You don’t need to earn a high return on this money. You need liquidity – the ability to get at it quickly. Access is more important than return.

The Basic Design Elements of an Emergency Fund

Your initial goal could be to build your emergency fund to $1,000. Once you have built that, you might try to build a reserve equal to one month’s worth of expenses. From there, the next goals might be to fund three months’ worth of expenses. Ultimately the fund should have six to 12 months’ worth of living expenses.

Having a larger emergency fund may make sense if you are 50 years or older. This is because losing your income later in your career could present additional risk. Many people in this age group experience longer delays finding acceptable employment than those younger. Some also find that it is impossible to fully replace the lost income. A larger reserve can help you manage such an unexpected transition.

The size of your reserve is important, but it should be noted that it is unlikely you will ever need all of the money at once. An emergency may require a portion immediately. And future withdrawals may be required later, depending on the type of emergency. Lost income is the primary emergency for which you should prepare.

Your emergency fund should allow for systematic contributions and easy withdrawals. Contributions must replace funds used for emergencies. The goal is to maintain a reserve of up to a year’s worth of expenses.

Buckets of Emergency Funds

You may want to consider your emergency fund as consisting of different layers, or buckets. For example, separate layers for very short-term emergencies, more medium-term issues, and then those that might be more chronic.

The short-term portion of your fund might be what you’d expect to spend in the first month of an emergency. Routine house or car repairs fall into this time frame. You would pay these out of this bucket. The most important factor for this first level of reserves is availability. You need to have immediate access to these funds.

A checking or savings account is perfectly acceptable for this level of reserves. This is especially the case if the account earns some interest. Additional funds in this bucket could be invested in a money market account. The checking or savings account might have a week’s worth of estimated expenses with the balance held in the money market fund.

The key is that you have immediate access to the money without delay or any surrender charges. This bucket also should be free of market risk. Your goal here should be to have immediate access and zero volatility.

Additional Layers of Your Emergency Fund

The short-term portion of your fund should handle emergencies that last one month or less. So, you should add a couple more layers on top of this to cover mid- to long-term expenses. But it can’t take long to get at the money.

It still has to be relatively liquid (e.g., two to seven day availability). It has to be accessible without penalty. And it shouldn’t be invested in anything that is too volatile.

The Optimal Size of Your Emergency Fund

The optimal size of your fund is determined by its structure. Your emergency fund should be expressed in terms of the number of months’ expenses it can satisfy before being depleted. For example, a typical emergency fund might have three to six months’ worth of expenses.

How Time Affects Your Emergency Fund’s Structure

It is much more likely that you will use your emergency fund to satisfy short-term needs. As time progresses, the chances of continued use of the fund decreases. Most people don’t need to rely on their emergency fund longer term. For the majority of people, the fund is exactly as it name implies.

While it is prudent to plan for longer emergencies, you will likely use the short-term portion of your reserves far more frequently than you will use the longer-term portion. You will simply be replenishing those funds from the longer-term bucket.

An emergency fund that optimizes liquidity and limits volatility (and surrender fees) might look something like this.

  • Bank Checking or Savings Account: one week’s worth of expenses
  • Money Market Fund: two to four weeks’ worth of expenses
  • Certificates of Deposit (CDs): laddered maturities beyond one month

Owning longer-term instruments that may be subject to surrender charges might also be appropriately earmarked as emergency funds. As time moves on, those maturity dates become closer. If the funds aren’t used, they fall into the short-term bucket and never incur a fee.

An example of this might include owing a three- or a five-year CD that includes a 60-day surrender charge. Odds are you won’t have an emergency that lasts this long. At a certain point, those CDs could be used to replenish short-term funds.

When all three buckets of your emergency reserves are well funded, and you have excess liquidity that allows you to save some portion of your income, then it makes sense for you to look beyond these short-term needs and begin planning for your longer-term consumption goals.

When that happens, take advantage of the advice and tools on the Member website and speak to a Member Service Representative if you need help navigating the available planners and calculators.

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