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The Right Size for Your Emergency Fund

This article was written by in Saving. 13 comments.


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 @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 13 comments… read them below or add one }

avatar CJ

You also have to realize that some parts of an emergency fund go towards things like family emergencies. What would happen if you had to take off 2 weeks of work and fly across the country to go to a family member’s funeral. You’d have to factor in 2 weeks worth of pay (if you didn’t have vacation pay), airfare, food (eating out almost every day), lodging, funeral expenses, lawyer fees, etc. It all adds up.

Also, I’d rather have too much than too little. Good article though.

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avatar GeekMan

I’ve always had trouble with figuring out the amount someone needs to keep in their emergency fund, especially for high earners with high living costs. For example, if a couple living in a big city had monthly expenses of $10,000 does that mean they should keep $60K IN CASH in the bank?! What if they have no outstanding debt, aside from a mortgage? What if their kids are just entering college? What if they could easily make those payments using only one spouse’s salary? What if, what if, what if? Basically, there must be some sort of cutoff amount kept in an emergency fund beyond which it no longer makes sense. If you earn enough to pay $10,000/month in expenses without being in financial pain then there HAS to be a better way to prepare for emergencies than keeping $60K in a cash emergency fund. Doesn’t there?

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avatar Kyle

I personally have 3 months in my emergency fund, which might be a bit on the low side. But if worse comes to worst, I could always liquidate some of my taxable stock portfolio to pay the bills if I had to. Once you have significant taxable investments, I think the need to have a large emergency fund diminishes somewhat.

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avatar Curt

Another thing to consider, is higher paying jobs usually take a longer time to find. So, if you are a CTO, it could take longer to find your next job. Therefore, the higher your salary the bigger your emergency fund should be.

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avatar Anca

For job loss, a better idea than relying on an emergency fund, is an emergency plan: always having an up-to-date resume, a list of companies or job sites to search, and an interview outfit. That will save time and money right off the bat.

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avatar Luke Landes ♦127,485 (Platinum)

CJ: That’s an excellent example of when you might need to use an emergency fund, and it can certainly add up. As Kyle mentions, you can have a multi-tiered set of emergency funds. I suggested five components, only two of which conform to the generally-accepted “emergency fund” term. So you can have a set amount in these first two tiers (cash on hand and liquid savings account) while using investments (and even credit if that’s a good option for an individual) for further emergencies. The Roth IRA is one of my favorites because you can access your contributions (not earnings) tax-free and penalty-free.

Anca: Very true. Always be prepared for unexpected job loss.

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avatar APFB

I have not taken the time to properly calculate my monthly expenses. We just have a lump sum that we continue to contribute to that we label as our emergency fund. As you said, if we had a reason to access our emergency fund, we likely would have reason to drop a number of other expenses.

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avatar JoeTaxpayer

The decision is tough. When I first started, I decided to load up the 401(k) and take advantage of the matching funds. I quickly had enough in the account that I could borrow $10,000 if I needed to. As my income went up, and I bought a house, I secured an equity line. While I had some liquid reserves, the rate on savings was so low, that my wife agreed we could just pay down the mortgage, refinance reducing both the term, and the rate, and know that the equity line was there in an emergency.

I think at the CTO level, these guys should have enough assets that the term ‘emergency fund’ doesn’t apply. They have assets they can tap for the purpose.
Joe

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avatar Clare

I’ve been thinking about these questions for a while now. Thanks for writing this.

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avatar ajc

I think that the right size for a fund that handles true emergencies is ZERO. Anything else is a provision, that you should be able to plan for …

After all, is it worth $8k a year for you to ‘insure’ yourself against emergencies with cash on hand, when there are so many other ways to do it that can actually MAKE you money?

Here’s some ideas just published today: http://7million7years.com/2008/08/13/more-on-emergency-funds/

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avatar Luke Landes ♦127,485 (Platinum)

AJC: Can’t agree with you completely. Some emergencies can be anticipated and you can plan for those accordingly (death of an aging parent, etc.) but there are many other things that cannot be planned for. You don’t want there to be much delay in getting access to funds when necessary, you don’t want to have added expenses (taxes, withdrawal penalties), and you don’t want to affect your long-term investing strategy. You also don’t want to experience an emergency while the only funds you have available are invested in the stock market or real estate when it happens to be a down year. You need at least a portion of your funds in low-risk, highly-liquid accounts.

Making money and protecting yourself in the event of the emergency are unrelated tasks.

A “market opportunity,” as you wrote about in your article, is not an emergency. Sure, you want to have funds available if you want to time the market or buy into a particular investment, and you can do that however you want (measuring the risk vs. anticipated short-term return), but most people wouldn’t consider a market opportunity an emergency.

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avatar BTG

Really interesting article. I remember when I was researching my “BTG Explains: what is an emergency fund” article I read everything under the sky about how much you should have in an emergency fund, and nobody considered the cost of moving. It didn’t even occur to me until I read this! I think this is a huge point that is really necessary, especially if the emergency fund is supposed to help cover you when you lose your job: moving is absolutely something you’d have to consider! I’m gonna go back and re-edit it my post to include your views on moving.

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avatar John

you should a have a few months worth of cash on hand, the rest should go to investments that yield higher. You can sell and move a stock investment into cash within a couple days, homeownership should only happen when you can put 20% down or more, and if you lose your job, worst case you should be able to a new job at the low pay end of your industry and can still pay the mortgage and bills, Therefore do not buy more house then you can afford. World population is growing, more people are competing for less money every day. You should always have a credit card to float you if you have to liquid some investments. Practice some minimalism in areas that might be consuming to much of your time and money, then you can handle change faster and quickly adjust to emergencies that so its not an emotional battle when something life altering happens, addiction of things means a bigger moving van, addiction to animals means more of your precious time and money. More children means added pressure to provide. lastly track your income and expenses each month to set yourself up for success so you know what you are spending on.

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