Emergency funds exist to take care of any urgent expenses that may arise. They prevent you from having to take any action that may damage your long-term finances, and are a key part of a healthy financial life. Where you hold your emergency fund is important to maximize effectiveness, so should an emergency fund be held in cash?
Emergency funds should be held in cash, stored in a high-yield savings account. Keeping an emergency fund in cash ensures it is safe and easily deployable in the case of emergency. Holding an emergency fund in investments or other assets is not recommended due to volatility and lack of liquidity.
Though other alternatives exist for emergency funds, cash is always king. Read on to learn about the other emergency fund considerations.
Why Should an Emergency Fund be Held in Cash?
Emergency funds exist to protect you in case of emergency. This could be a job loss or an urgent expense (e.g., car/home repair). When the need arises, you want to have quick access to the necessary funds. Holding your emergency fund in cash ensures you can access the money immediately, in the amount that you expect.
When considering an emergency fund, the two key parameters are that it is liquid and safe.
You want your emergency fund to be liquid so you can immediately access the money. Stocks and bonds are less liquid, as they need to be converted to cash before being used. Other assets like your home and car are even less liquid. Holding an emergency fund in cash means it’s already in the necessary format, maximizing accessibility.
When it comes to safety, you want to ensure the money you need is there in the amount you expect. Imagine you lost your job and rather than holding cash, you were holding your emergency funds in stocks. If the job loss coincided with a market crash (which they often do), you could have significantly less in emergency funds than you expect. By holding your emergency fund in cash, you ensure the value never goes down.
Holding your emergency fund in cash ensures both safety and liquidity in the case of an emergency.
What is the Best Emergency Fund Account?
The best emergency fund account is a high-yield savings account.
As mentioned above, the best emergency fund is one that is liquid and safe. A high-yield savings account holds the emergency fund in cash, meaning it’s already in the necessary form. It also is safe, and the value will not go down. This means that the money will be there when you need it.
High-yield savings accounts also allow for a small amount of growth on your money (a couple percent) while you’re holding it in case of emergency. Now this will not be near the growth you get from investing, but helps to minimize the effects of inflation.
By holding an emergency fund in a high-yield savings account, you are keeping the money in a safe and liquid account, while also allowing for some growth.
Is Holding Physical Cash for an Emergency Fund a Bad Idea?
Though holding physical cash is both safe and liquid, it means your money will lose value with inflation. As such, holding physical cash for an emergency fund is not recommended. Instead, it’s recommended to hold the funds in a high-yield savings account.
Most modern central banks aim for ~2% inflation rate. This means that the purchasing power of your money decreases by 2% every year. So, if you held $10,000 in cash, next year you would only be able to purchase the equivalent of $9,800 in goods. By holding your emergency fund in physical cash, you’re slowly losing purchasing power. By holding it instead in a high-yield savings account, you may not be able to completely keep up with inflation, but you can decrease it’s affects.
The other consideration with physical cash is the accessibility. In our increasingly digital world, more and more payments are done electronically. Many places may not take cash, or you may need to deploy the money to make an online purchase. Holding the money in physical cash means you may need to wait a few days for a deposit to clear, rather than if you hold it in a bank and can access it immediately.
In general, physical cash is not recommended for an emergency fund.
How Much Do I Need in My Emergency Fund?
In general, it’s recommended that you hold 3-6 months of expenses in your emergency fund. Now it will be up to you what you consider a necessary expense. It will also depend on your life and risk factors to determine the number of months of expenses to hold.
To determine how much your expenses are each month, it’s necessary that you track your spending. From there, you can get an understanding of how much money you spend each month. You can also classify which things could be dropped in case of an emergency. The remaining expenses form your monthly amount.
The next thing to consider are your risk factors. These could include the following:
- Do you work in a volatile job/sector where job loss is common?
- Do you own assets that could need emergency repairs (e.g., car or home)?
- Do you have dependants that rely on your income?
- What happens if you run out of money?
Depending on the answers to those questions, you can determine how many months of emergency fund to hold. If you are low risk, you may decide to hold 3-4 months. However, if you have a lot of risk factors, you may instead decide to hold 5-6 months. The number of months you choose can then be multiplied by your monthly expense amount to determine the dollar amount to hold.
Once you’ve got your dollar amount, work the savings into your budget to start building your emergency fund.
Emergency funds provide a shield for your financial life, and by holding it in the proper account and format, you’re maximizing the effectiveness.