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Lots of experts….lots of opinions….it depends who you ask.
When it comes to deciding how much cash you should keep lying around for an emergency fund there is not a one size fits all answer. The most typical answer that I have heard is 3-6 months of expenses with some experts even saying that we should keep closer to 12 months of expenses in liquid cash accounts as a rainy day fund.
It’s up to you!
Your emergency fund needs to be tailored to your particular situation. It needs some thought put into it and like most things in life requires some intentionality. I am going to run through a few examples to get your brain thinking about what you might need for an emergency fund. Ultimately, the decision is yours, how much do you need to have peace of mind without leaving excess piles of cash in an account that yields little to nothing.
Do me a favor first
Don’t be like the average American!
This infographic from Forbes is excellent! It shows that almost 70% of Americans have less than $1,000 in their savings account. That is unreal to me! These people are setting themselves up for disaster. One small misstep could send their finances into a tailspin.
Here’s the thing, some is better than none. Dave Ramsey suggests starting out with a small $1,000 emergency fund while you are getting out of debt. This would probably work for most people who are serious about getting out of debt and don’t plan on depending on that emergency fund for more than a couple of years. This is exactly what I did and it worked out just fine.
First, let’s look at Daryl. Daryl is a 20-something that is married but has no kids. He has paid off all of his debt, does not own a home and him and his wife both have stable jobs that are in a high demand field. In other words, they would both be able to find another job fairly easily if something were to happen to their current state of employment.
Daryl is probably at the low end of the spectrum. He could get by with three months of expenses in his emergency fund and be just fine. Some might even argue that three months is too much and I wouldn’t necessarily disagree with them. Now let’s look at an example from the other end of the spectrum.
Bonnie is a divorced mother of three adult children. Bonnie is in her mid 50’s and has decided not to re-marry. She has a high paying job but given her age it may be difficult for her to find a job in her field with similar pay. She has done a decent job of saving for retirement but has not yet reached the age that she can withdraw from these accounts penalty free.
Because of the divorce she ended up refinancing her home and still has 5 more years until the mortgage is paid. Since Bonnie is a one income household, is not quite ready for retirement and still has a mortgage payment to make every month it may be wise for her to have an emergency fund that covers 6 months or more of expenses.
What is your risk tolerance?
Everyone has a different threshold for risk and some may feel more comfortable and secure having 12 months of expenses in an emergency fund. I think that could possibly be a bit excessive but if you have good reasoning for it then I won’t argue with you. There would have to be some very extenuating circumstances for me to believe that a person would need anymore than 12 months of expenses in a liquid account.
Remember, this is money that is just laying in an account making you practically no interest income. I enjoy peace of mind but it comes with a price. The more peace of mind that you want the more potential income you are losing out on.
It comes with a cost
To show a very simple example of what an emergency fund could be costing you let’s look at someone with $3,000 of monthly expenses. If they had a small emergency fund of say $10,000 (nice round number) and it is yielding next to nothing in the bank, what kind of gains are they losing out on?
As you can see in the above example using an 8% annual return there is the potential to make/lose out on a lot of money. Compound interest is amazing!
The point I am trying to make here is that with anything in personal finance there needs to be intention. Don’t just throw together an emergency fund and hope that it’s enough. What is your tolerance for risk? How much would you feel comfortable having in this account keeping in mind that the above chart shows what this “peace of mind” is costing you in lost interest income.
What I do
For me personally, I keep 3 months of expenses in a liquid account. My job as well as my wife’s are very stable and we both work for well established companies that take good care of their employees. We also live well below our means and could get by on one income if we needed to. Every person’s emergency fund is different. There are many factors that come in to play including whether you are renting or own your home (your rent can go up at anytime but a major repair can also happen at any time on your house), the stability of your job and the stability of the company that you work for, whether you are a one or two income household, you and your families overall health, etc. How much do you like to have in your emergency fund for peace of mind?
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