Step 3 of the Baby Steps program is to save three to six months of expenses in an emergency fund. This fund is not supposed to be used for shopping sprees, vacations, cars, sofa specials, or anything of that sort; only for true, emergency situations like a job layoff or medical incident.
What to spend that money on when the time comes has not been too much of an issue in my experience. The more common question has been where to park this fund when it is being built or after it has been built.
The best place to park your emergency fund is just in a regular money market savings account. I do not recommend putting it into any other type of account, like a Certificate of Deposit, investment account, and certainly not a retirement account.
When an emergency happens you’ll need that money as quickly as possible, and having it reduced through fees or taxes will not help your situation.
“But it’s not earning me anything there!”, the objection often goes. Yes, that’s true, but the point of the emergency fund is not to earn you money. Your emergency fund is an insurance policy, not an investment. An insurance policy costs you something, but it is a defensive tool that will ensure that you don’t fall backwards when life throws curveballs your way.
That said, it’s not a bad thing if your emergency fund earns a little bit of interest while it sits there. A lot of banks, like Bank of America, Chase, Wells Fargo, etc. offer really, really low interest rates, somewhere in the 0.02% area a lot of the time.
However, other banks like Ally offer up to 2.20% on savings accounts. If you have $10,000 in your fully-funded emergency fund, that’s $220 a year you’d earn. And that’s not a bad thing by any means! The important thing with your emergency fund is ensuring that it will not lose value and that it is accessible (but not too accessible).
The emergency fund is an important component of a solid financial plan. One who does not have an emergency fund is effectively asking for trouble. Murphy (whatever can go wrong will) loves to strike those who can least take the blow. That savings account, which is never touched except for emergencies, will help to stave off trouble, and when it does come around, simply turn it into an inconvenience instead of a catastrophe.