Financial Foundations #2 - Your Emergency Fund
What is an Emergency Fund?
An emergency fund is an account that is typically funded with 3-6 months’ worth of expenses, set aside in an account all to itself, and is one of the least attractive ways to utilize money, but is one of the soundest decisions you can make.
Just about anyone who has tried to level up their finances has probably heard of the emergency fund. Some may think it’s a very inefficient use of money and others understand that it brings an immense amount of peace and readiness for when life strikes.
The purpose of this fund is to use when an emergency strikes and you can’t pay for it from your normal flow of cash from the income you have and avoid going into debt. This would include things such as:
A loss of a job
Insurance deductible required to repair your home or vehicle from major damage
Insurance deductible for health care
An out-of-pocket expense/uncovered medical bill
Home air conditioner replacement
Home appliance repair or replacement
Travel for family crisis
Pet emergencies
We don’t plan on these types of things happening or going wrong, but we live in a real world where we know those things happen sometimes unexpectedly. Without adequate cash to pay for these, people often go to a credit card (20-30% interest rates) or withdraw from investment accounts (that may come with taxes, penalties, and being out of the market where it no longer has the potential to earn money).
How should I calculate my emergency fund number?
The best way to do this is to refer back to our previous discussion on cash flow (HYPERLINK). For a quick (and recommended for retirees) estimate, take a look at debt payments, expenditures, and property taxes. If you calculated those on a monthly basis, you can add all of those up to get your monthly amount you would possibly need. This also helps in the calculation from a job loss perspective, but will also typically cover most major incidences described above.
However, you could take it a step further in your analysis. The primary function is for us to look at this from a job loss scenario. Debt payments have to be made, so include those. However, your expenditures may decrease. If you commute to work, you may spend less on gas if you weren’t driving in. You may decide to not eat out if you’ve lost your job (or as much). Perhaps you’d cut a subscription service for a period of time until you found another job. So you could reduce or eliminate some expenses for this scenario.
Should I use the rule of Three months, Six months, or something else?
Now that you know your monthly number, should you multiply that by three or six to get that many months of expenses covered, or something else? It depends on comfort and time you’re looking to buy. There are a few variables that can help with that based on your family make up:
Married and both working - You may consider three months worth of expenses as it’s unlikely both of you lose your job at the same time. One spouse will still be earning an income while the other looks for a new job.
Married and one spouse stays home - Consider six months worth of expenses so the working spouse has enough time to find a job that fits best for the family.
Married and retired - Consider three months and review your investment allocation for additional funds that may be needed as withdrawals.
Single with kids - consider a minimum of three months, but increasing that up to six months is acceptable. This buys you some time to find the next job that works best for your family.
Single and no kids - three months is probably a good target because you’re the only one depending on you.
Of course, you can increase this amount, but we don’t want to increase it so much that money is idling sitting and not working like it should.
What kind of account should I keep this in?
There are a few options here:
Savings account - you can earn some interest on this.
Money market account - most banks offer this with minimum balance requirements and limited withdrawals. They typically pay a higher interest rate for this reason.
Brokerage account - utilizing money market mutual funds in a brokerage/investment account is one of my favorite ways. There are several types of money market mutual funds and I would encourage you to look at treasury or government money market mutual funds because they maintain the value of a dollar. These are short-term type investments and can be converted to cash within a day given the market is open and you get the sell in before the close.
If you’re ever tempted to dip into your emergency fund for something other than an emergency, then you may consider keeping it a different financial institution than where you do your day to day banking.
How often should I revisit this number?
We recommend you re-evaluate this annually with your cash flow and make any adjustments necessary. It will rarely go down (perhaps if you pay off a debt it will) and may go up just a bit. If you’re earning a decent interest rate on your money and the interest is just being reinvested, you may not need to add any additional cash to it!
Check out other Financial Foundations topics: