You’ve probably heard this before, but you need to have an emergency fund set up. This likely isn’t news to you. But, just like it isn’t news to you, it probably isn’t news to the average person. Then why is it that 58% of people in the United States don’t have enough money in an emergency fund to cover 3 months of expenses?
The world is a crazy and unpredictable place, and things happen. The loss of a job. Unexpected medical expenses. A leaking roof. The heater in your home stops working. Your car won’t start. The list goes on.
But if any of these happened to you, how would you pay for it? Without an emergency fund, you’d be forced to look for cash in places where you may not want to take it. Pulling money from a retirement account incurs penalties. Selling stocks or bonds when you have to may result in losses and dampen your future savings prospects. Racking up credit card balances comes with unbelievably high interest rates. Yes, you might be able to cover the bills, but at a significant premium to the actual cost.
Enter the emergency fund.
By keeping a reasonable amount of money set aside in a highly-liquid account, you are able to avoid the unfavorable aspects associated with the options above, and still pay for these unexpected life events.
The most frequently quoted advice on how much money to set aside in your emergency fund is somewhere between 3 and 6 months of expenditures. I think this range is right, but where you fall on the range is a function of your individual situation and your risk tolerance.
You can lean towards the smaller end of the scale if you:
1. Have stable employment
2. Have fewer people depending on your salary
3. Are a member of a multi-income household
4. Are geographically located near family that could support you if needed
5. Have a higher risk tolerance
6. Have other priorities for your money (i.e., paying down high interest debt)
You should consider leaning towards the higher end of the scale if you:
1. Have uncertainty in your current employment situation
2. Have family members or others dependent on your income
3. Are the sole breadwinner for your household
4. Live in an area where jobs are less plentiful or in a highly competitive job market
5. Have a lower risk tolerance
Personally, I advise people towards the higher end of the spectrum, knowing that you don’t have to come up with the lump sum of 6 months’ expenses all at once. Building a plan to increase your emergency savings over time is actually the best way to approach this.
For example: Let’s say your living expenses (excluding discretionary spending) are $2,400 per month. Let’s also assume that after taxes, you bring home $3,800 per month. If you are targeting a 5 month emergency fund, you’ll be looking to build the amount to $12,000.
A plan to get there may be as simple as setting aside $1,200 per month until you reach the bottom of your comfortable emergency fund range (let’s say 3 months’ of expenses, or $7,200). Once you reach the minimum of your comfort level, you can reduce the amount you put away toward your emergency fund to $700 per month until you reach your target 5 month fund. Following this plan, you’ll reach your target emergency fund in about 13 months, but you will have reached your minimum fund in only 6 months. Taking a tiered approach such as this allows you to build towards a safety net while increasing your available money once a bare minimum has been reached.
One important note about emergency funds to keep in mind is that this money needs to be liquid and accessible. You don’t want to have it invested incase the market hits a downturn and you find yourself with an underfunded emergency fund but are in a situation where you may be forced to sell your holdings for a loss. Additionally, while they generally offer more attractive savings rates, CDs are also financial instruments to avoid for emergency funds because the fees associated with accessing your money early will negate the increased interest you may have otherwise earned.
I highly recommend finding an online bank that offers high interest rates, but that has no minimums and no fees to transfer the money out for easy access. I would recommend taking a look at banks such as Ally or Marcus to fit this bill.
It may also be worth having a separate account set up that isn’t your primary checking or savings account. Depending on your level of financial tracking (and possibly self-control), you may find yourself inadvertently dipping into your emergency fund and forgetting to replenish it. The point of this money is truly for emergencies, so finding that you don’t have the necessary money when you need it is only shortchanging yourself when you may need it the most – adding financial stress to what is likely an already stressful situation.
It’s impossible to disagree with Eric on the importance of having an emergency fund. As someone who has gone through company layoffs before, I’ve been in situations where I’ve asked myself, “do I have enough money to hold me over if I lose my job?” That is a very scary situation to be in, and even more so if you have nosort of financial cushion to fall back on. Ignoring the job-loss scenario, there are several major life events that would be hard to face without an emergency fund. I can think of two big ones in the last year alone that happened to me:
- Furnace replacement at one of my properties – $6K
- Emergency crawlspace repair work at our main home – $15K
A good question to ask yourself is, “how would you handle the above situations?” If you don’t have a good answer to that, that’s probably a sign you need an emergency fund.
The first key point Eric makes above is that your emergency fund should be based on your life situation. He’s totally right. While he gives it a three to six month range for an emergency fund, I would argue that both ends of that should be extended. If you’re someone with almost no obligations, your emergency fund probably doesn’t need to extend past one month. A situation where this may apply would be if you’re right out of school and living with your parents. I also know people who are actively looking to change their career or make a major transition in life. If this is the case, and you have a family, you might want to have an emergency fund of a year or more. I have friends who have even built up enough liquid assets to be able to live two years or more without income coming in.
While we can debate the criteria for an emergency fund all day, the thing to keep in mind is that you don’t want to be caught in a situation where you need to take on a significant amount of high-interest debt to cover costs that can be planned for in advance. Life has a tendency to take a turn for the worse when we least expect it, and the best thing we can do is prepare for it beforehand.
The second major point Eric brings up is how to put together your emergency fund. While putting money aside monthly is a great way to start, there are other approaches you can take that may not feel as burdensome.
What if you took your tax refund and used that to start your emergency fund? The average tax refund in the U.S. ranges from $2,200 to $3,200, depending on what state you live in. That’s a great way to commence your plan and lessens the sting of the monthly payment. If you work in a job where youget some sort of bonus, that’s another option. There are many areas in your life you can evaluate in order to begin this journey. It should not seem like a daunting commitment.
Here at Thriving Millionaires, we talk a lot about how you can make small life changes or smart investments to better your financial well-being for the long-term. While this will always remain the case, it’s critical to ensure you plan for the “expected unexpected”. We all want to believe that our crawlspace is in great condition and that our furnace will never break down, but deep down we know that’s not true. Let’s make sure we plan for these life events so they don’t get in the way of thriving for the future.