How to set and invest your emergency fund
Emergency funds are designed for the moments when a household budget gets interrupted—job loss, sudden medical bills, or major repairs—without pushing people toward expensive borrowing, according to a Morningstar personal finance guide by Christine Benz. The guide frames the purpose as protecting basic costs and supporting long-term financial stability, including by helping people avoid draining retirement accounts when unexpected expenses hit.
Benz notes that many financial messages about emergency savings focus on an “ideal” size of three to six months of expenses, but she says that approach can feel discouraging for people starting out. She argues that the strategy can be made more approachable by focusing on first steps and on how the money can be held so it remains available when needed.
The guide lays out a five-step process for building an emergency fund. Benz’s first step is to determine essential monthly living expenses—housing, utilities, food, debt payments, insurance, and taxes—while leaving out discretionary spending. She says the starting target is to multiply those essential expenses by three months, creating an “absolute minimum savings target” for an emergency fund.
Benz adds that the minimum should then be customized. People with irregular income, such as contractors, should build larger cash buffers, while those facing jobs with high salaries may need to plan for situations where comparable work could be harder to find. She also ties the appropriate size to how easily households can cut spending and relocate, saying new graduates who can move back with family or into lower-cost living arrangements can often begin with a smaller buffer, while households with mortgages, multiple car payments, children, and related expenses generally need a larger emergency fund.
In her second and third steps, Benz says savers should first determine how much they already have toward that goal. She recommends adding cash in checking and savings accounts, money market accounts, and certificates of deposit, while excluding money earmarked for other purposes such as a down payment or college tuition. She also says cash held inside stock or bond mutual funds should be excluded from the emergency-fund total. Subtracting current emergency-fund assets from the essential-expense target then produces the minimum amount a saver still needs to add, and Benz describes hitting that number as the main priority for the months ahead.
Benz emphasizes that an emergency fund should be invested with liquidity and low risk in mind rather than optimized for extra returns. She advises using plain-vanilla cash instruments such as checking and savings accounts, CDs, and money market accounts, while noting that online savings accounts and credit unions often offer competitive yields. She also cautions that some product types aren’t FDIC-insured—for example, she says money market mutual funds do not qualify for FDIC protection—while money market accounts at banks are FDIC-insured. Her guide also points out that CDs can carry penalties if money is withdrawn early.
Finally, Benz addresses where to hold the emergency savings. She says the goal is access without taxes or penalties, which generally means keeping the cash outside retirement accounts. Still, she notes that a Roth IRA can function as additional backing because contributions can be withdrawn without penalty, though earnings are not treated the same way. For homeowners, she adds that some may consider arranging credit in advance through a home equity line of credit (HELOC) that can be used if the emergency fund runs out, advising that setting it up while employed can be easier than trying to obtain it later.
Benz writes that emergency funds are crucial at every life stage, outlining practical benefits such as preventing reliance on high-cost financing, defraying unexpected expenses like a new roof or healthcare costs, protecting retirement accounts, and covering basic costs in case of job loss.
Note: This article is based on a guide provided to The Associated Press by Morningstar. Christine Benz is director of personal finance and retirement planning for Morningstar and co-host of The Long View podcast.