Where to Save Emergency Funds and What Matters Even More

A key component of personal finance is maintaining an adequate emergency fund, a pool of liquid cash that you can access in case of unexpected expenses or an interruption in income.  This allows you to handle life’s inevitable bumps in the road without resorting to credit card debt (and facing exorbitant interest rates), retirement account withdrawals (which might involve significant taxes and penalties), or investment account withdrawals (which might involve capital gains taxes and market timing risk).  A typical rule of thumb is that clients should set aside enough to cover three to six months of non-discretionary expenses and any large planned cash purchases.  

For almost 4 years now, short-term interest rates have exceeded 3 percent, significantly outstripping short-term rates of the preceding decade and a half.  And with the recent increase in bond yields, short-term rates might push higher over the next few months.  That being said, short-term rates remain significantly below the level of long-term average annual returns that an investor might expect from a balanced, well-diversified investment portfolio.

What does this mean for your emergency fund?  First, if you are still holding most of your emergency fund in a traditional bank checking or savings account earning 0.01 percent, you are missing out on earning a competitive interest rate.  Second, if you are holding considerably more cash in your emergency fund than six months of non-discretionary expenses, you may also be missing out.  Since average annual returns for a diversified investment portfolio exceed short-term interest rates by several percentage points, there is an opportunity cost to holding more cash in your emergency fund than is necessary when you could be investing a portion of it instead.

Where to Save.  As mentioned, your emergency fund should be kept in a liquid investment to provide for easy access without any penalty for withdrawals. Having a savings account at your local bank might be easy in terms of transferring money from savings to checking account without delay, but an online savings account will likely offer a higher interest rate.  For example, national banks with local branches, such as Wells Fargo and Bank of America, offer between 0.01% and 0.05% on savings accounts, and credit unions, such as Apple and Navy Federal, offer between 0.10% and 0.25%, depending on the type of account and amount held in it.  In contrast, online-based savings accounts with Ally Bank, American Express, and Marcus by Goldman Sachs offer 3.00%, 3.00%, and 3.40% annual yields, respectively.  (Money market funds and CDs at local banks or credit unions may sometimes offer comparable rates, but they often require significant deposits or have restrictions on accessing cash, so the online savings accounts still have an edge in terms of flexibility.) Alternatively, traded money market funds, such as the Schwab Prime Advantage fund (SWVXX), may offer slightly higher yields (currently over 3.50%) but involve a bit more coordination to transfer cash in and out of the fund.

What Matters Even More.  Moving your emergency fund from a bank or credit union to an online savings vehicle or traded money market fund could certainly make a noticeable difference in the annual interest you receive.  However, an even more significant decision regarding emergency funds is how much to keep in reserve for that potential emergency.  Imagine, for example, a person earning $120k per year, who could safely cover 6 months of non-discretionary spending with $40k in an emergency fund but— given fears about the market, inattention to her accounts, or some other reason— has built up an emergency fund of $100k.  The surplus $60k, even with an interest rate of 3.40%, would earn $2,040 for the year, as compared with $4,200 if the funds were invested in a balanced portfolio of stock and bond mutual funds, assuming a 7% annual return.

Choosing where to save your emergency fund could result in a few hundred (or even a few thousand) dollars of additional savings each year, but purposefully choosing how much to save in your emergency fund (and investing the rest) could result in much bigger financial gain by ensuring that you have neither too little money, nor too much money, set aside in case of emergencies.