The purpose of an emergency fund is to have money available in case unexpected expenses crop up so that you don’t have to use high-cost debt to pay them.
Emergency Fund Size
Traditional financial advice suggests you have three-to-six months of your living expenses in liquid assets, such as a savings account. So what expenses do you need to include? Include those expenses that you would have to pay each month if, for example, you lost your job. Using this example, it would include housing costs, debt payments, as well as living expenses (food, entertainment, fixed expenses such as insurance payments and utility bills).
Make three categories of your expenses:
- Fixed payments (mortgage or rent, student loans, car or personal loans, life and health insurance premiums)
- Housing expenses (such as utilities, cable, cellphone, homeowners’/renters’ insurance)
- Living expenses (such as food, entertainment, day care, travel, gas, shopping)
Add those three categories together to see how much money you need each month. If you have a stable job and don’t expect any major changes, then an emergency fund of three months is fine. For example, if your expenses are $6,000/month, then an emergency fund of $18,000 is sufficient. If you are self-employed, have a temporary position with variable income, expect a job change, or are downsizing, then six to 12 months are more reasonable, possibly even longer.
I often am asked if there is debt still on the books (e.g., credit card debt, or a car loan) does it make sense to keep a six- or even a three-month emergency fund that is not earning any interest. Wouldn’t it be smarter to pay off the debt? My answer is usually a cautious yes. If the debt is high interest rate debt (such as credit card debt), then it makes financial sense to pay it off and then rebuild the emergency fund. Indeed carrying high-interest rate credit card debt is only to be done in a true emergency.
Other Emergency Fund Features
How do I replenish the fund after drawing it down after an emergency? If you are saving 20% of your salary, divert some of your savings for a short period to the fund to get it back up to the appropriate level.
I suggest using a savings account for at least three months of total expenses. Any amount beyond that can be placed into a three or six month CD or an ultra short bond fund. Credit unions often have great rates. Home equity lines of credit also count toward your emergency fund. For example, if you have $10,000/month in expenses, then you could have $30,000 in a savings account and a $30,000 home equity line of credit available, for a total of 6 months. Having a large emergency fund sitting in cash may not make much sense if you have HELOC capacity and sufficient cash flow each month to replenish your emergency fund.
3 questions to ask yourself about your emergency fund:
- Do you know how much you spend each month?
- How big an emergency fund do you need?
- Is the emergency fund in a savings account or could you put some in a CD or use a HELOC for purposes of your emergency fund?
The answers to these questions should serve you well in case you need to dip into your emergency fund unexpectedly.
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