The #1 rule of personal finance is to have an emergency fund.
Every financial guru from Dave Ramsey to Suze Orman to Ramit Sethi to yours truly, Engineer Your Finances, recommends you have one.
According to CNN, “nearly a quarter of Americans have no emergency fund.” That’s 1 in 4 people!
What is an emergency fund?
An emergency fund is an amount of money set aside to cover situations that occur outside of your day-to-day expenses. Emergencies are unexpected and unpredicted events, and generally, expensive.
An emergency fund allows you to avoid putting anything on a credit card. Examples of an emergency include car and home repairs, emergency room visits – for you or your pet. The most valuable use of an emergency fund is to cover your living expenses in the event of a job loss.
How much money should you have in an emergency fund?
Well, it depends. There is no magic number, and like all things personal finance, the decision is personal. However, the general guidance is 3 to 6 months of living expenses.
The first thing you should do is to take a look at your budget and add up one month’s worth of expenses for your rent/mortgage, utilities, car payment, insurance, food, and gas. Include other expenses that you need to pay each month. Some expenses are negotiable, and you can cancel them with no penalty. For instance, you can cancel your cable bill or place it on hold while you find another source of income.
Multiply your total monthly expenses by 3 for the lower range of your emergency fund and multiply by six for the higher range.
How much should you save if you’re in debt?
The variables to consider whether your savings should be on the low or the high end of the range are based on things such as the stability of your income, the gap between your income and expenses, your adversity to risk, how much debt you have, and how risky your lifestyle is.
It’s a good idea to start with $1,000 – $2,000. $1,000 will cover most minor emergencies, or allow you to make a substantial down payment for the repair. However, this is not nearly enough.
If you’re in debt, your goal is to save $1,000. Once you have your initial fund saved, refocus your priority to paying down your debt. Save in order to cut debt here.
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How much should you save if you’re debt-free?
Once you’re debt-free, three to six months of living expenses is your aim. If you have a secure job, or you live in a large market so you can expect to find a job quickly, you can save towards the lower end of the range.
If you have a large family or live off one income or your job is in an unstable industry, you’ll want to aim for the high end of the range.
Remember, the idea of an emergency fund is to provide security for you and your family. If you are averse to risk and thrive off security and comfort, which I’m guessing you do since you’re reading this article, you can aim for even higher than six months. There is no cap – the sky’s the limit.
The Argument Against a Large Emergency Fund
There is a strong argument not to leave so much money in liquid savings if your goal is growth. While having a safety net can be nice, liquid assets don’t bring in a lot of growth. Six months’ worth of expenses can be a lot of money, and if you direct some of that money into a 401(k) or mutual/index funds, you can get ahead of the game as far as growth is concerned.
So, how much money should you have in an emergency fund if growth is your goal? Three months’ worth of expenses is a good place to stop. This will free up more capital, and allow you to take advantage of your income to build your future.
The choice is yours.
Are you 1 of the 4 with no emergency savings?
Leave a comment and let me know.