According to the Federal Reserve, about 37 percent of Americans cannot raise $400 in cash to pay for an unexpected expense. This is a situation to avoid. An emergency fund provides a critical safety net; it is always advisable to set some money aside for unexpected expenses in liquid investments.
Unfortunately, the more liquid your investment is, the less interest it will earn. But you can strike a balance between earning interest and having ready access to your emergency funds.
What Is an Emergency Fund?
An emergency fund is a bank account in which money is set aside to pay for unexpected, sometimes large expenses: things like medical care, home appliance repairs, major car fixes, or regular bills after an unexpected job loss. An emergency fund may contain cash or other highly liquid assets.
An emergency fund gives you a financial buffer so that you don’t have to depend on credit cards or high-interest loans in time of need. The fund should be large enough to pay for three to six months of regular expenses, and it should be kept in accounts that enable you to withdraw money immediately and without financial penalty.
Is It a Good Idea to Invest Your Emergency Fund?
Although it is possible to invest the money in your emergency fund, it is not always a good idea. If and when you need to use the money to deal with an emergency, you need it in the short term. In the long term, the U.S. stock market yields good annual returns that average up to 10 percent. But returns in the short term are very volatile, and you don’t know exactly when you may need to use your emergency fund.
Another critical consideration is liquidity. The liquidity of an asset has to do with how readily it can be converted into cash. Even if you can sell most investments quickly, it usually takes a few days before the broker settles the transaction and deposits the cash in your brokerage account. Then you need to transfer the cash to your bank account, which may take another several days. If you need the cash pronto, you may be forced to borrow from another source and pay interest.
Here are other pros and cons of investing your emergency fund.
1. The Pros of Investing an Emergency Fund
Investing your emergency fund in money market accounts, high-yield bank accounts, tax-free savings accounts (TFSA), or certificate of deposits (CDs) enables you to earn interest.
Investing your emergency fund helps ease the financial stress of situations like a sudden job loss or unexpected auto troubles.
Investing your emergency fund helps cultivate the habit of saving. When you have the goal of investing, you are motivated to reduce spending on nonessential goods and luxuries, and you strengthen your financial position.
Avoidance of Bad Debt
Investing your emergency fund helps you avoid bad debt. If you have such a fund, you won’t consider using high-interest credit cards to fund your daily needs.
2. The Cons of Investing an Emergency Fund
Low Interest Rates
The more liquid your money is, the less interest it will earn. In the U.S. money market, the interest rate paid on emergency funds is as low as 1 percent. This return is quite low for a significant investment risk.
Lower Financial Contributions
By investing in an emergency fund, you reduce the amount of money available for your retirement savings and other financial contributions, like paying down a mortgage.
The value of money may be higher now than it is likely to be in the near future. Investing an emergency fund now means that you lose the opportunity to earn higher returns by investing in other areas like the stock market.
When to Consider Investing an Emergency Fund
Having an emergency fund helps you avoid debt in case of an emergency. Liquidating the fund helps you pay for unbudgeted expenses like medical costs, home repairs, and car repairs. If you have long-term debt, having the fund available helps you stay focused on getting out of debt. Moreover, investing an emergency fund limits access to it, which helps you avoid unnecessary withdrawals except in the case of emergencies.
If you have only one source of income—and especially if you are the sole breadwinner in your family—your contribution to an emergency fund should be substantial so that you can financially weather setbacks like an incapacitating illness or a job loss. At MoneyWizard.co, we suggest that you set aside enough money to pay for at last one year of expenses.
If you have a serious medical condition, you can easily max out on deductibles every year. In other cases, your insurer may not pay for everything. You may also need to take routine tests the cost of which adds up pretty fast. If you exhaust your paid sick leave, you may have to take unpaid days off from work. A solid emergency fund can help you cope with the challenges.
Other reasons to consider investing an emergency fund including saving for a specific goal, living far from your family, or owning your own home.
Understanding What Is Safe and Liquid
You can’t predict when you will need your emergency money. So the safety and liquidity of your emergency fund should always be a top priority. Your account options include the following:
1. High-yield bank accounts
High-yield savings accounts operate much like traditional savings accounts but offer higher interest rates. However, the interest rate is not high enough to beat inflation, so your money loses part of its buying power over time. With regard to emergency funds, however, the safety and liquidity provided by a savings account are tough to beat.
2. Money market accounts
Money market accounts are a hybrid of savings accounts and checking accounts. Many of these accounts are covered by the Federal Deposit Insurance Corporation (FDIC). Typically, they offer higher interest rates that are equal to or better than the interest rates of high-yield savings accounts. You can easily access the cash in a money market account by using checks, a debit card, or an ATM.
3. Certificates of deposit
Certificates of deposits offer much higher interest rates than money market accounts and high-yield bank accounts. However, with CDs, you must lock up your money for a set period that you choose when opening the account. The longer it takes for the CD to mature, the higher the interest rate. The longest term tends to be five years. With a CD, then, you can earn more money on your cash, but you must pay penalties if you withdraw from the account before the set time has expired. Given the possibility of penalties and the unpredictability of emergency situations, using your emergency fund to invest in certificates of deposits is riskier than other options.
4. Tax-free savings account
A tax-free savings account is a great investment for your emergency fund. You can use it to save for different purposes throughout your lifetime. You can invest in cash, stocks, bonds, GICs, mutual funds, and other investment vehicles. Contributions, dividends, interest, and capital gains on a TFSA are not taxed. You may also contribute whether you are employed or retired.
You can contribute as long as you like. The amount you are allowed to contribute is called contribution room. If you do not use all of your contribution room in a given year, you can carry the balance forward to the contribution room of later years. Any money you withdraw is added to your contribution room at the beginning of the following year.
An emergency fund covers you and your family in case of a financial emergency. Investing the fund helps you to earn interest, avoid bad debt, increase your savings, and improve your financial security. With an emergency fund, your peace of mind is secure. Establish an emergency fund before venturing into other revenue streams, like stocks. Although building a portfolio yields higher returns in the long run, the stock market is highly volatile. Returns may decline in the short run because of a recession or other events. If you want to invest your emergency fund, consider using safe and liquid investment vehicles like high-yield savings accounts, money market accounts, tax-free savings accounts, and certificates of deposit.