This is the fourth part of a series on setting up a financial plan.
The beginning of the series is here.
The previous article is “5 Accounts, #2 – Online Savings”.
The next article is “5 Accounts, #4 – Investment“.

I think everyone instinctively knows that they should have an emergency fund, but like many other pieces of financial advice and/or common sense, it often gets put off or bypassed. The cause is the same as that of most common financial missteps – the fact that our brains simply aren’t wired to think sensibly about the future – why plan for a financial disaster which may never come, when we can live right now?

There are too many things which might require an immediate financial “bridge” – major car problems (if you commute by car), a sudden medical expense, an unexpected layoff… if any of these things “catch you short” you could be seriously stuck, forced to rely on a credit card or a loan to get by, at which point you end up in a fresh new financial hole full of unwanted interest payments.

So if keeping an “emergency fund” on hand is a good idea, what’s the best way to go about it?

Since this is for emergencies, it needs to be accessible in short order, so we want something like a savings account or a money market account which will allow us to withdraw/transfer money immediately. So why not use our online savings account?

There are two needs an online savings account doesn’t quite meet.

1. We want this money to stay “saved” – mixing it in with all the current account sweeping and discretionary considerations muddies the water, and tempts us to spend “emergency” money on non-emergencies.
2. We should be keeping this money around, unused, for the long term. So we need as good an interest rate as we can get, to protect our money from inflation.

A good alternative is an online-accessible money market or high-interest savings account.

There are two accounts which I mentioned yesterday, and which are consistently recommended by finance writers for the purposes of an “emergency fund”:

1. EmigrantDirect’s AmericanDream SavingsAccount (5.05% APY at present)
2. ING’s Orange Savings Account (4.50% APY at present)

These are, like other bank accounts, FDIC insured to $100,000 (meaning you won’t be out of pocket if the bank goes FOOM!), and are therefore extremely low-risk. There really isn’t much to choose between them, although EmigrantDirect’s slightly higher interest rate is obviously attractive, and is the account I’ve chosen for that reason.

ING score highly for customer service, and also offer investment services and other accounts, so if you want to simplify your finances somewhat by consolidating transactions within one bank, that may be an advantage.

So, once we’ve identified our account, onto the next consideration – how big should our emergency fund be? Trent at The Simple Dollar has a pretty good summary of this, taken from his rewrite of a 2006 CNN article containing “25 Rules to Grow Rich By”. His post goes into more detail, but the basic rule he comes up with is this:

Keep two months’ worth of living expenses in a bank savings account or a money market account for each person in your household. So, if four people live in your household, have eight months’ worth of living expenses.

That sounds pretty sensible to me – it covers the worst possible financial calamity (sudden redundancy), and should provide a healthy amount to deal with other mishaps too.
Finally, it’s perfectly possible to build an emergency fund in “stages” – set a first stage target of $2500, say, then focus on other financial priorities for a while before coming back to “boost” your fund to a safer level. Even $2500 squirreled away is better than nothing.

As to those “other priorities”, my main one (investment) is up next…

Disclaimer: I’m not a financial advisor, and I’m just sharing my own financial plans because, well, I like to share. It’s also a good exercise in “thinking out loud”. You choose to follow any advice in these posts at your own risk, though – I’m not responsible if you overdraw or suffer other financial calamity…

The “Savlon” photo on this post is from PrASanGaM on Flickr. Savlon liquid is, in fact, one of the few things in the world I’m allergic to – its fumes cause me to cough uncontrollably and it’ll give me a mild but irritating rash if it comes into contact with my skin. Still, for most people it’s good for emergencies…

This article first arrived on the interwebnet on Friday, August 17th, 2007 at 1:00 pm .
It's arbitrarily categorised as being about: Finance, Financial Planning, Thinking.
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You know, this article used to be 4000 words longer, but right before I pressed 'Save', the dog ate it. Honest.