Emergency Fund Size: How Much Of An Emergency Fund Do You Need?
Bad stuff happens. It's a part of life. At some point, your car will break down. You will suffer through a job loss or a medical emergency. And when those things happen, you'll want to focus on the things that matter and not money.
This is why a stocked emergency fund is part of every solid financial plan. But what is the right emergency fund size? Three months worth of living expenses? Six months?
The truth is, it depends on what your monthly living expenses are, and how long you'd need to cover them in an emergency. The rule of thumb is you need to cover three to six months worth of expenses. In this post we'll cover what an emergency fund is, why you need one, and what your emergency funds size should be.
What is an emergency fund?
An emergency fund is money you set aside in the long term for when an emergency happens. For example it could be used for unexpected events like when you lose your job or suffer a medical emergency. Traditionally an emergency fund covers around six months of living expenses.
I recommend you actually have two different kinds of emergency funds. The first one, called a "resiliency fund" is focused on short term cash flow issues. It's particularly useful when you are working on getting out of debt. This is because you typically keep a really low balance in your bank account, and there isn't much margin for error in case a surprise comes up.
The second emergency fund you’ll set up will be your traditional six month emergency fund. This fund should be fairly big and cover a substantial emergency, like a job loss. Most articles about the basics of personal finance will say you don’t build this emergency fund out until you are fully out of debt, excluding your mortgage. There are two reasons for this.
- You don't have much money, so saving up six months of savings is very hard.
- When you’re getting out of debt, financial cushion can make you complacent. You need to stay motivated.
How much should I have in an emergency fund?
Truth is you the specific emergency fund size should reflect what you need to feel secure. I keep mine sufficiently stocked to cover the full six months of living expenses. Because that's what makes my family and I feel secure. Which is really drives the root of this. Having this additional savings set aside provides my family additional insurance and security. And that's the only metric that matters here.
The whole point of the fund is to provide a sense of calm that you can tap into during a crisis. How much emergency savings you need is up to you. Coming from a place of being over $100,000 in debt...I like a lot of calm and security in my life.
Where should I keep my emergency fund?
It's best to think of your emergency fund as just that, a place where you can quickly access some emergency cash. Because of that, you shouldn't worry too much about what growth it may get, so you can keep it in a traditional high yield savings account or money market accounts. If you are concerned about investing you should look into a traditional or roth IRA.
Once you build up more wealth, you may want to look into creating a cd ladder emergency fund. This involves setting up multiple certificates of deposit, each with different maturity dates. The benefit is that you earn some growth on your savings due to the higher interest rates, without putting it at risk.
One thing I recommend when it comes to setting up your emergency fund is to set it up in an account that is not with the same bank that your primary checking account is. The reason for that is because it creates some natural friction in using it since it typically takes a few days to transfer funds between account not at the same bank, which helps raise the bar on what an actual “emergency” is.
What is resiliency fund?
A resiliency fund is a smaller fund, usually around $1000. It's the first one you should build, as it's meant to smooth out bumps in the road so you can stay on track while you pay down your debt. It's best to use a stand savings account linked directly to your primary checking account. It allows for quick access and overdraft protection, helping you address any unexpected expenses or minor emergencies.
The resiliency fund is your first line of defense, while your emergency fund is your last resort.
How much should I have in a resiliency fund?
I'd recommend you keep around $1000 in your resiliency fund. Why $1000? Because in an emergency, $1000 gives you a moment to take a deep breath and devise a plan before doing something rash.
According to a recent survey conducted by Bankrate.com, over 60% of American’s couldn’t cover a $1000 emergency without going further into debt.
Here's an example to help illustrate this point:
Imagine you are driving to work one morning and you pass a construction site. Unfortunately that causes you to puncture your tire with a nail. The mechanic recommends two new tires so that they wear evenly. This will cost you around $500. Talk about adding insult to injury!
Depending on your situation, a scenario like this can start a domino effect in which some bills get paid and some don’t. Of course, this sends your stress levels through the roof, all while you’re trying to do the right thing; working on getting out of debt.
If you had a resiliency fund you could withdraw $500 from there, get the new tires, and replace the money at the next opportunity.
Your resiliency fund serves a very specific purpose
Here is the critical thing to remember: when you pull money from this account, replenishing it should become your top priority. Until it’s back up to normal, any extra cash flow should go there, instead of towards your debt. It’s a critical buffer that will keep unexpected expenses from becoming huge setbacks.
It allows for quick access and overdraft protection, helping you address any unexpected expenses or minor emergencies to smooth out bumps in the road so you can stay on track while you pay down your debt. It’s a savings account in which you keep $1,000 that’s linked directly to your primary checking account.
Resiliency fund example: The impact of an unexpected expense on your budget
Let’s say your average monthly income and average monthly expenses look like this. Every two weeks you get paid around $2,500. But after you’ve paid your bills, expenses, and debts, you’re living paycheck to paycheck. This balancing act becomes a job in itself!
So let’s imagine that it’s about six days into the month and your car breaks down, requiring a $500 repair.
The surprise of this sudden expense creates a temporary cash flow issue that can have a domino effect on your ability to pay other expenses. This typically results folks having to make late payment on cars, student loans, home mortgages or even take on additional credit card debt.
Now using that same scenario, let’s imagine you had a $1,000 resiliency fund in place.
When your car trouble arose, you would be able to dip into your resiliency fund to cover the $500, saving you the scramble to juggle expenses.
Once you addressed the temporary issue, you would then make it your top priority to replenish the fund. This little buffer can have a huge impact as it keeps you from going into firefighting mode, and provides a little breathing room to think through the problem. When you’re fighting to get out of debt, that time can mean the difference between a rash reaction and an intentional decision.
So those are the different types and amounts of emergency savings you need. Once you have them in place, you’ll focus less on “saving” and more on “investing”, which we’ll talk about in a future post. Just remember that your actual emergency fund size is subjective, so you need to trust your instinct. You may start with a larger one and slow right size it or vice-versa.
If you have one of these already, leave a note in the comments and tell us about a time it saved your butt!