When you are first trying to get your financial house in order, one of the first suggestions that always comes up is “Start an emergency fund”. What are some reasons an emergency fund is so important and so frequently suggested?
1. It helps protect you against loss of income
As of this writing, approximately 8 million Americans are unemployed. No matter how secure your job or career seems, there is always a chance you’ll be unemployed for at least a short amount of time. I remember growing up in a fairly nice neighborhood and having a lot of wealthy neighbors – occasionally, they would lose their homes seemingly out of the blue, many of them due to losing their jobs or facing a substantial decrease in income.
Losing your job, getting a paycut, or losing hours doesn’t need to be a financial disaster, however. A good emergency fund will tide you over while you look for a new job, help supplement unemployment income you get, and give you the peace of mind to look for the right job, instead of taking the first thing that comes along.
2. It makes large, unexpected expenses less stressful and financially ruinous
Most people will, at one point or another in their life, face a situation where they have an uexpected need for a moderate to large amount of money. Medical issues, car repairs, house repairs, broken appliances, legal fees – just to name a few. If you don’t have an emergency fund built up, these expenses could be a real shock to your finances.
People who don’t have emergency funds set aside for these situations find themselves borrowing money at outrageous rates, missing payments on other obligations, and falling behind financially. This needn’t be the case – if you have money set aside, an unexpected large bill is still unpleasant, but you can use your emergency funds to pay it and get on with your life.
3. It gives you peace of mind and confidence to spend money for fun
When you know you have money set aside for unexpected events like losing your job or facing a large medical expense, it relieves a lot of stress. It also makes it easier to spend other money on fun things, like vacations, nice dinners, fun toys, etc.
How do I build an emergency fund?
Building an emergency fund can seem challenging, and if you don’t have much saved right now, getting to your emergency fund goal can seem daunting. The most important thing to do is to get started. Building an emergency fund should be one of your top financial priorities – ahead of setting aside money for your children’s education, ahead of setting aside money for a down payment on a house, ahead of investing (although, at least investing enough in your company’s 401k to get the match, if available, could be done).
Look through your current monthly spending to find a few dollars here and there – maybe go out to eat one or two fewer times per month. Rent a movie instead of going to the theater sometimes. Hold off on a few discretionary purchases here and there.
There are definitely people who have virtually no room in their budgets for an emergency fund, but most people can find a few bucks here and there – your future self will thank you for setting aside this money.
How much should I have in my emergency fund?
How much you should set aside is something that is frequently debated – most people will tell you between 3 and 12 months worth of expenses. How much you should set aside depends on a handful of factors:
- How steady is your income? If you are salaried, you probably need less than if you work on commission or are self-employed.
- How stable is your job? If you work in a career that is in high-demand, work at a stable company, and generally have good reviews, this is better than working in a career that has a negative outlook, for a company that is struggling (or a startup), or have reason to believe your performance at work is below where it should be.
- How elastic are your expenses? Can you cut a lot out of your budget? Do you rent, or do you have a mortgage? These all factor into how much you should have saved.
- Is there another income earner in your household? How much of your expenses can they cover?
- What is your health like? What is the state of your car and your home? Are they likely to need substantial repairs in the near future.
Let’s look at two examples:
John is a 28 year old, single, software developer. He’s been with his firm (which has been profitable for some time and has never laid off an employee) for 5 years and has received high marks in all of his reviews. He spends around $4,000 per month, $1,000 of which is completely discretionary. He rents an apartment and has a 10 year old Toyota Corrolla that he drives.
How much should John keep in his emergency fund? He has a stable job in a good field, and works for a company that looks stable. About 25% of his spending could be cut back if needed. His car seems a bit old, but is a model that is seen as generally reliable. He doesn’t have any other income, though. The ideal emergency fund for John would probably be in the 6 month range, but I’d argue he could start channeling a decent amount of money to other investments once he hits around 4 months of expenses, and let the last 2 months build up slowly. Of course, there’s nothing wrong with aiming higher.
Jeff is a 43 year old paper salesman. He is married with 3 kids. His wife, Brooke, works part time, earning about 1/4th of their monthly expenses. Their expenses are $6,000 per month, about $500 of which could be cut back if need be. Jeff drives an 8 year old BMW and his wife drives a 7 year old Audi.
Jeff’s situation is a little different. His job is at least partially commission-based, so his income isn’t as stable. He has 3 kids, which increases the chance of needing to pay for medical expenses unexpectedly. His wife works, but only covers a portion of their expenses. They both have older cars, models that aren’t quite as reliable and are more expensive to repair.
Jeff and Brooke are likely to face more unexpected expenses, and less stable income. I’d recommend they start with a 6 month emergency fund (~$36,000) and then slowly increase it to 9 months or so.
Everyone’s situation is different and everyone has different tolerance for risk, but hopefully this gives some decent guidance for figuring out how much you should save.
Where should I keep my emergency fund?
Emergency funds should fairly liquid – the whole point is that you may need to access the funds relatively quickly. An online savings account is a good place to keep it. CDs can be ok, too, so long as you have ways to end the CD term early.
Many people advocate a tiered approach that may look something like this (for a 9 month cushion):
1 month in checking
2 months in savings
3 months in CDs that can be cashed out early (with penalty)
3 months in low volatility mutual funds (government bonds, etc)
This allows them to access a portion of their emergency fund virtually instantly, but has some of it sitting in accounts that earn a little bit more interest (to help keep up with inflation). If you only have 3 or so months of savings, this tiered approach probably isn’t appropriate. Regardless of how much you have, keeping it all in savings is never a bad idea, either.
The important things are: 1) it is kept in accounts that aren’t volatile (stocks are not a good place to keep emergency funds), and 2) they can be liquidated relatively quickly.
What qualifies as an “emergency”?
Once you’ve built up that cushion, it is hard to stare at it and stretch the meaning of “emergency”. Job loss, medical issues, car/house repairs, and unexpected legal expenses are all good candidates for using this fund. Really good deals on vacations, down payments for a car or house, and other things of the like aren’t great ways to use this fun – what if you used the money for a down payment on your house, then had something happen the first few months after you moved in?
It is a good idea to review your emergency fund from time to time. Your situation in life may change. Your expenses will fluctuate. Inflation may eat at how long your fund can last for. Interest earned from your fund may outpace inflation (but not likely). So it is a good idea to review it every year and make sure it is still meeting your goals.
Hopefully this has been a useful overview of emergency funds. Feel free to leave questions or comments below!