A reader by the name of Slinky came by and left a comment on the site:
I’d love for you to post about pros/cons of storing an emergency fund in different places – online savings, money market, index, brick and mortar, etc.
The key to figuring out where to stash your emergency cash is decide what type of emergency you’re preparing for. Many people save “3-6 month’s expenses” in their emergency fund, in case they lose their income for a few months. Other people have emergency funds for sudden incidents, such as car repairs or a medical crisis. Some people keep cash in case of a natural disaster, where banks and ATMs might not be available.
What’s the difference here? “Liquidity.” Liquidity simply means “how easy will it be for me to get the money I need, fast?” Different accounts give varying levels of liquidity – and usually the less liquid your fund is, the higher rate of interest it will earn.
Under a mattress, in a fireproof safe, or in a sealed envelope on your person – cash is about as liquid as it gets. Cash is good if you’re the type that would use your fund in a natural disaster.
Pros: Instantly useable, accessible during a power outage
Cons: Loses value over time due to inflation, is inaccessible if you’re not physically near it (if it’s in your fireproof safe and you’re out of the house, for example), little recourse if it’s stolen, temptation to spend on non-emergencies
Brick-and-Mortar Bank Savings Account
The savings account at your local bank or credit union could be the place for your fund. It’s highly liquid – you can get the money out by walking into a branch, using your ATM card, or instant transfer to your checking account at the same bank.
Pros: Easily accessible, less temptation to spend than cash
Cons: Low interest rate usually doesn’t keep up with inflation (loses value over time), may be inaccessible while traveling if bank is local
Online (High Yield) Savings Accounts
One of the most popular places for emergency funds right now, online savings accounts offer the sweet spot of liquidity and interest rate. The funds can be transferred to your checking account within 1-3 days. Recommended account: ING Direct’s Orange Savings.
Pros: Interest rate usually meets or beats inflation, transfers to checking account, separation from checking decreases temptation to spend, no minimum balance requirement
Cons: Slow transfers may hinder urgent emergencies, limited by federal law to 6 transfers out of the account per month
A money market savings account is a lot like a high yield savings account, without the “online” part. They pay a comparable interest rate to online savings accounts, sometimes even higher. Also, they let you write a few checks a month on the account, assuming the check is for $250 or more (usually).
Pros: Interest rate usually meets or beats inflation, transfers to checking account, ability to write checks for emergencies
Cons: Limited number of checks can be written per month, minimum balance requirements could be a problem if you have to use all the money in the emergency fund
Index funds are just a collection of stocks that follow the stock market. Low liquidity and high volatility – some people use index funds to grow the value of their emergency fund, but it’s a risky practice because your fund could take a nose-dive in value right before you need the money for an emergency!
Pros: High interest rate, low liquidity virtually guarantees you won’t spend it on non-emergencies
Cons: Really inaccessible (you have to sell the funds to get the money), could lose value when you need it most, could virtually disappear during economic crisis
Extra: Credit Cards
Many people keep a credit card around for emergencies. In my opinion, a credit card is a compliment to an emergency fund. You use the credit card to pay for the emergency, and then use the money from an emergency fund to pay off the credit card balance.
Pros: Emergency fund that is easily accessible and as big as your credit line, accepted by nearly every retailer and some medical facilities, ability to “pay now” and then pay off the balance with money from your real emergency fund
Cons: Temptation to overspend or use for non-emergencies, usually not usable in the case of a power outage
Use a combination of these options to get the benefits you need. For example, If you’re in hurricane or tornado territory, having part of your emergency fund in cash is a good idea, as well as having some in a high yield savings account.
Personally, I’m using a credit card/online savings account combination right now. After I graduate from college and grow my emergency fund, I’ll move most of the fund to a money market savings account, and perhaps keep a couple hundred dollars in cash as well.