Unless you’re new to personal finance you’ve definitely heard of an emergency fund. It’s become a common phrase thrown around but often without actual numbers provided. I’m an active member on Reddit where I try to help answer financial questions, and one of the most common questions is “how much emergency fund should I have?” This post is going to walk you through the purpose of an emergency fund, where you should store your emergency fund, and how much emergency fund you should have.
What is an Emergency Fund?
An emergency fund is exactly what it sounds like, it’s a savings account in case of emergencies. Perhaps the Coronavirus pandemic shed some light on how important this account is, as millions of Americans were either laid off or saw their incomes drastically reduced. I wrote about the astonishing trend of millennials having less than $1,000 in their emergency funds here.
A properly funded emergency fund is in place in case you lose your job, or a global pandemic occurs, and you cannot make enough money in income to pay your bills. This is why the amount to put into the fund is often debated. I’ve counseled people who feel $1,000 is enough of an emergency fund. I’ve had people tell me their emergency fund is mixed within their savings account. In my opinion, neither of these are viable options for how much emergency fund you should have nor where it should be stored.
An emergency fund doesn’t only help protect against emergencies. It can also be used to buy some time when you need it as I recently experienced in my personal life. My wife and I recently moved across the country. Because of our 6 month emergency fund she was able to slowly navigate the job landscape to secure the offer she wanted instead of rushing into getting hired immediately. Our emergency fund allowed us to help with any bills before she started getting a paycheck. This peace of mind is one I hope everyone can find.
How Much Emergency Fund Should I Have?
As mentioned in the intro, this is a debated question. The consensus is somewhere between 3 to 6 months of expenses. How do you come up with this number? You simply look at your monthly spending plan and see how much money it takes to run your life. This includes rent/mortgage, bills, groceries, and so on. This is why there isn’t a set figure for everyone. It wouldn’t be right for me to tell you to save $4,000 as your emergency fund if your monthly expenses are $2,000 for example. Once you calculate your monthly expenses, I like to round it up to the nearest $1,000. For example, if your monthly expenses are $3,700, I would round that up to $4,000. I do this mainly because the math is easier and I’m lazy.
Now that you’ve calculated your monthly expenses and rounded up the nearest $1,000 you simply multiply that number by 3 and 6 to answer your question of how much emergency fund should I have? The reason I multiply both 3 month and 6 month totals will be explained below. For someone just starting out on their financial journey, these emergency fund projections might seem insurmountable. This is where getting on a spending plan will help you, if you need help with this I wrote a guide here.
Where Should Your Emergency Fund be Stored?
Another common question I get is where the actual funds should be stored. Because this is a fund separate from your savings I feel it should be stored separately from your savings. The fund should be in either a high-yield savings account (here is my guide) or a money market account. This keeps the money completely liquid, which means easily withdrawn when needed. Some people keep their savings and their emergency funds together, but this allows for some grey area which is always best to avoid in personal finances. I personally keep our emergency fund in a separate bank account from all other money and recommend you do the same.
Advantages to a Separate Account
- First, you can quickly see your account total using a mobile app and know if your fund is where it should be. If you are combining your emergency fund with your savings then you will constantly have to do the mental math of subtracting the emergency fund from the rest of the money in the account. This is a guaranteed way to make mistakes.
- Secondly, by keeping it in a separate account you reinforce to yourself subconsciously that this fund has a specific purpose. While logging on your brain is thinking “this is my emergency fund account.” This helps ensure that you will only remove the money in the account for emergencies.
- Third, if your fund is in a different account you won’t be tempted to transfer funds to your checking for impulse purchases.
- Finally, you can set up a monthly deposit into this separate account while building your fund. If the fund is mixed with another savings account then this is trickier. Instead, you can set up a monthly payment to your account and watch the total grow.
For these reasons, I highly recommend keeping your emergency fund in a completely separate account.
How Much of Your Fund Should Be Liquid?
I just said that your emergency fund should be easily accessible in case of an emergency. Though this is true, there is a caveat that I like to suggest. I recommend people save the first three months of their emergency fund in a savings account as mentioned in the previous section. This will cover you for all monthly expenses if you lose your job for three months. This amount should also be enough in the case of an unexpected medical, vet or mechanic bill.
It’s not always wise to keep all six months of your fund in cash, however. Financially, you could be losing out on interest. This is why I invest the second three months of funds in three month CDs and use a CD ladder. Traditionally, CDs earn more interest than a savings account. This is true even for small duration CDs that are only 3 or 6 months. What I recommend is you put months 4, 5, and 6 of your emergency fund into separate 3-month CDs. As each CD expires you simply place it back into a new 3-month CD. This method allows for two things. First, it allows half of your emergency fund to grow at higher interest rates. Second, if you do lose your job for more than three months, the first CD is maturing right when you need it so it is still liquid.
One side note, CD rates are negotiable. Often banks will try to re-enroll your money automatically at a lower rate. If you check current rates you can either move your CD to another location or call your bank and tell them about the rate offered elsewhere. They would much rather match that rate and keep your money. You can always check current CD rates on bankrate.
What Happens Once the Fund is Funded?
Another common question is what happens after I have 6 months of expenses saved? The correct answer to this depends on your financial goals. This is where having a written financial plan comes in handy, which I walk you through here. After you’ve accumulated 6 months worth of emergency fund expenses there is no reason to add more to this account. This is another example of why having the account separate from other money is so nice. You can just leave the money there, sleeping peacefully knowing that if an emergency occurs you’re covered.
When you have to dip into the fund to cover unforeseen expenses you can do so knowing you prepared for this moment. Once the storm has passed you can work on rebuilding the fund to the same level. I assure you that once you go through one situation where a properly funded account protects you you’ll never go without it.
That being said, I don’t recommend saving more than 6 months worth of expenses in your emergency fund. It’s simply there for peace of mind when life happens. How many times have you been without income for 6 months?
Key Points
The key points to this post can be summarized as:
- Your emergency fund should be in a separate account, or even institution, from other savings
- Calculate your monthly expenses. Multiply the price to “keep the house running” by 6 to determine your fund’s goal amount
- Keep at least 3 months of your emergency fund as liquid as possible. Keep the fund in either a savings account or money market account
- You can use a CD ladder for the remaining three months fo your fund to increase interest earned
The Wallet Diagnostics
The Coronavirus pandemic has resulted in nearly 50 million Americans filing for unemployment. This should serve as a wake-up call to everyone on the importance of having an emergency fund. The toughest part about creating your fund is getting on a budget so you can start filling the fund adequately. The peace of mind that comes with knowing you have 6 months’ expenses covered no matter what it worth any sacrifices you have to make while budgeting. If you have questions on your particular situation feel free to reach out to me on Reddit, Twitter, Facebook, the comments below, or our contact form found to the right.
FAQs
How much of an emergency fund should I have? ›
While the size of your emergency fund will vary depending on your lifestyle, monthly costs, income, and dependents, the rule of thumb is to put away at least three to six months' worth of expenses.
What's the 50 30 20 budget rule? ›The basic rule of thumb is to divide your monthly after-tax income into three spending categories: 50% for needs, 30% for wants and 20% for savings or paying off debt. By regularly keeping your expenses balanced across these main spending areas, you can put your money to work more efficiently.
How much does the average person have in their bank account? ›| Year | Median bank account balance | Average bank account balance* |
|---|---|---|
| 2019 | $5,300 | $41,600 |
| 2016 | $4,790 | $42,580 |
| 2013 | $4,500 | $39,690 |
| 2010 | $4,120 | $38,000 |
Most financial experts end up suggesting you need a cash stash equal to six months of expenses: If you need $5,000 to survive every month, save $30,000. Personal finance guru Suze Orman advises an eight-month emergency fund because that's about how long it takes the average person to find a job.