One of the most popular pieces of financial advice is the importance of establishing an emergency fund, money that can be accessed to assist with life unexpected problems, like medical emergencies or the loss of a job. Financial advisers like Suze Orman suggest that most people have ready three to six months’ worth of expenses in “liquid” savings — easily accessed — ready to go to help cover a rainy day.
I’ve suggested breaking your emergency fund into five components, but it’s the first two components that relate directly to the nearly universal definition of the emergency fund. Having cash on hand and in liquid bank accounts will help you deal with a sudden loss of income or a significant financial need, but money kept in this manner loses value over time due to inflation. Any money kept in the emergency fund is not maximizing earning potential as other investments could be. The goal is to find the right balance between allowing your savings to earn money though compound interest or appreciation and forgoing performance for accessibility.
How do you determine how much to keep accessible? As I mentioned, many experts suggest having three to six months’ worth of expenses ready to go. That’s a wide range and not very helpful. For example, for me, that could be anywhere from $12,000 to $24,000. Here are some questions to help you determine a more personalized amount.
Start with your monthly expenses. If you already track your income and expenses somewhat accurately with software like Quicken then you have your starting point. Keep in mind that your monthly expenses for this purpose include your spending plus your debt payments. Include your electric bill, even if you pay by credit card. If you have outstanding debt, include your monthly payments for your credit card, mortgage, student loans, or any other service that applies.
Look at the stability of your income. What would you do if you lost your job? Are your skills in high demand? If so, you may find a replacement for your income quite quickly. If this is the case, you have an argument for keeping the balance of your emergency fund on the shallow end. While your personality will determine how much risk you’re willing to take, and you are taking more risk by keeping a small emergency fund. Even though you may perceive your ability to find a new job earning the same amount will allow you to find you a new job within one month, it would be beneficial to assume that forces possibly beyond your control will prevent you from doing so.
Keep in mind that job markets cycle, so you may need to reevaluate your situation from time to time. Labor demand and supply change. If you established the “rules” for your emergency fund in 1999 when high tech jobs were in high demand, if you had lost your job in 2002 you may had been out of work for longer than you expected.
How far are you willing to go? If you might have difficulty finding a job to replace your income, are you willing to consider alternatives? Some people are willing to do whatever it takes to make ends meet, even if it means taking a job for which they are overqualified. If your industry suddenly becomes unfavorable, will you work as a waiter for minimum wage while determining the next course of action? If you need to devote all your waking hours to find a new job, then you’ll need a larger stash than if you can split your time between the job hunt and a temporary job.
How much would it cost to move? I would say that an unexpected necessary move would be a strong use for an emergency fund. If your job is requiring you to move to a new town and they are willing to pay for your expenses, you do not need to worry about this, but there are many other reasons why you might need to find residence in a new town. For example, perhaps a family member could become ill and you need to move closer to provide care and support. Consider your variable moving expenses as well as any expenses you might have while you settle in your new location. These should be covered by your emergency fund. If moving requires a new job, add more to your emergency fund to cover your expenses.
Are you willing to reduce your expenses? Desperate times call for acts of desperation. Chances are you have expenses you can eliminate if you are out of work. If you’re willing to say goodbye to high-definition cable television, the wine of the month club membership, and the gardener, feel free to leave these expenses out of your calculations when determining your ultimate emergency fund goal. But only do so if you’re truly willing to give up these luxuries.
It is rare to hear someone say, “I had just the right amount in my emergency fund.” Almost always you will have too much or too little, but those who have too little drive the most popular stories. It’s next to impossible to foresee all possible situations and plan your emergency fund perfectly. It’s best to err on the side of caution even if that means you’ll have less available for investing. Accept the fact you won’t get it exactly right and do the best you can.
The savings account I label “Emergency Fund” has about two months’ worth of expenses, but it’s held at ING Direct. If I needed this money in cash, the quickest way to get the money would be to to transfer the amount to a local bank account and withdraw the funds. This process would take a several days, so I have in place a multi-level emergency plan which consists of cash on hand, money in ING Direct‘s account, more money in several high-yield savings accounts, and, if necessary, I could sell investments (and draw a tax bill) or use available credit (and risk the need to pay interest expenses).
Updated September 17, 2011 and originally published August 11, 2008. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.