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How much do you really need in an emergency fund?

How much do you really need in an emergency fund?

August 08, 2023

This month I wanted to address a question that I have been getting recently.  It revolves around how much cash you need in liquidity before really starting to invest outside of a retirement plan.  The amount of money you should keep in an emergency fund depends on several factors, including your individual circumstances, financial goals, and risk tolerance. While there is no one-size-fits-all answer, a common recommendation is to have enough funds to cover 3 to 6 months' worth of essential living expenses. I look at this slightly differently.  I typically recommend clients keep 25% of gross income in cash (with a maximum of $50k unless there is a short-term need, like a down payment for a house).  This fund acts as a safety net in case of unexpected events, such as medical emergencies, job loss, or unexpected repairs.  One thing that often gets lost is cash is not the only place you can access in an emergency.  I often recommend a taxable investment account that can also be used as a life events fund.

To determine the specific amount for your emergency fund, consider the following factors:

  1. Monthly Expenses: Calculate your average monthly expenses, including rent or mortgage, utilities, groceries, insurance, transportation, and any other essential bills.

  2. Income Stability: If your income is stable and secure, you might lean toward the lower end of the recommended range (3 months). If your income is more variable or your job is less secure, you might consider saving closer to 6 months' worth of expenses.

  3. Risk Factors: Think about the potential risks you face. Do you have dependents? Are you in an industry with high job volatility? Do you have health issues? These factors can influence how much you need to save.

  4. Health Insurance: Having adequate health insurance coverage is crucial. Medical emergencies can lead to substantial expenses, so having insurance can mitigate this risk.

  5. Debt: If you have high-interest debts, like credit card debt, many people want to pay that off first.  My recommendation is to secure your emergency fund, and then pay the debt down.  It is true that you are going to end up paying more interest, but if you focus on the debt first, then you are very likely to go back into debt as soon as something unexpected pops up.  The goal is to change the behavior and prevent going back into debt if possible. It is great to pay off consumer debt, but it is far more valuable to have options when something unexpected comes up.

  6. Other Savings Goals: Consider your other financial goals, such as saving for retirement, buying a house, or investing. Balancing your emergency fund with other financial priorities is important.

  7. Local Considerations: The cost of living varies based on where you live. Urban areas generally have higher costs, so adjust your emergency fund accordingly.

  8. Risk Tolerance: Some people feel more comfortable with a larger emergency fund, providing a greater sense of security, while others might be comfortable with a smaller one due to a stable job or strong safety net.

Remember that your emergency fund is not meant to generate high returns; its primary purpose is to be easily accessible when needed. You can keep the funds in a separate savings account or a money market account with low risk.

As your financial situation changes over time, it's important to reassess and adjust your emergency fund accordingly. The goal is to strike a balance between having enough funds to handle unexpected situations without tying up too much money that could be better used elsewhere.