How Big Should Your Emergency Fund Be
Every Monday, we address one of your pressing personal finance questions by seeking advice from several financial experts. If you have a general question or money issue, or just want to talk about something PeFi-related, leave it in the comments or email me at [email protected].
This week’s question comes from Vince B :
Is it important to maintain a reserve fund when you are relatively financially secure? That is good credit, decent sized index investments, etc. It seems like a waste of money to keep a few thousand when I could just put it on a card or margin loan.
(Disclaimer to advice: This is what individual experts usually say about an issue that affects each person differently – if you need personalized advice, you should see a financial planner.)
Do you need an emergency fund
Vince, Vince, Vince. The short answer is yes, ideally you should have emergency supplies, even if you feel financially comfortable enough. Don’t you want to stay that way, even through life’s ups and downs?
“Emergency funds are for unplanned expenses and contingencies — in other words, for life,” says Scott Cole, a certified financial planner based in Alabama. “Life does not stop because a person is financially secure.”
But, okay, that’s easy to say, triggering some kind of amorphous emergency. Let’s take a look at all the forms that he could take.
It is true that if you had one of the classic emergencies covered in personal finance magazines – say, your car needed a repair or you had a medical emergency – you could always have it on your credit card and pay it off every month. returning more in interest. But suppose a medical emergency turns into a full-blown crisis that takes you out of your job, or you lose your job altogether. If you are seriously ill, your credit limit is probably not high enough to be used indefinitely. And if you get fired, there is no guarantee that you will find a job within a reasonable time frame. Then you just dig deeper and deeper.
“A good reputation is good; good index investments are also good. But none of them are designed for emergencies, says Mitchell Hockenbury, a certified financial planner. “Good Credit” simply gives you the opportunity to take out a loan. You still have to pay the expenses. “
These are worst-case scenarios, and it is to mitigate them that a reserve fund is created. Nobody thinks they need an emergency fund when things are going well. But think: how stable is your job really ? What about family members who might need help? “The Emergency Fund is not an investment. This should be viewed as a self-funded insurance policy, ”says Daniel Schultz, a certified financial planner based in Illinois.
How large this fund is depends on your circumstances.
How big should your emergency fund be
We are all familiar with the three to six month spending range for a contingency fund, but what does that actually look like? “The size of the emergency fund needed should depend more on what the person spends, rather than on what he needs ,” says Schultz.
You are calculating the “critical” costs – not all the additional costs that make up our daily lives. For example, do you have an expensive mortgage or rent that you can’t refuse? Do you have student loan payments? Do you need to be able to drive to get to work?
“A guy with only a few thousand dollars in an emergency fund will almost certainly not have enough funds to cover the costs if he gets fired and takes eight months to find a new job … or has to leave his apartment due to an accident … fire, ”says Schultz. “And if any of this happens during a market crash, he could lose significant money on investments that were liquidated out of necessity.”
However, Vince, you may not need to accumulate money depending on what your investment looks like. “One of the key factors is having a sizable investment pool that they can rely on without tax penalties in the event of a major emergency,” says Mike Kastler, financial advisor. “This could reduce the amount needed in the emergency fund.”
If you have a well-diversified portfolio (and how it looks depends on your personal situation) and you don’t mind taking risks, then some of your assets can probably be swapped out for a reserve fund. “It’s great if your emergency fund is less than 20 percent of your taxable investment,” says Birke Sestok, a certified financial planner . “Above 20%, you are probably risking too much.” You don’t need to keep a ton of money in a 0.01 percent savings account or a pile under your mattress.
Alternatively, “many of our clients will use CDs or short-term bond funds, which can pay a higher interest rate than cash in a bank,” Sestok says. “High-income people may consider using short-term municipal bonds to lower their taxable interest rate.”
But then again, investing – or “maximizing” your money comes with its own risks. Risks that you probably cannot afford if you are in the midst of a financial crisis.
“I understand that we all want to maximize our money by sitting around,” says Hockenbury. “I’m just warning you that as you build wealth, very few people will complain about making a little $ 10,000 or so when that provides a margin of safety. Never forget that all assets are at risk in one form or another. ”
As Tyler Gray, a board-certified financial planner , notes, the rule of thumb is three to six months, in general, based on the size of your thumb. “Some people will sleep best at night knowing that they have three to six months in an FDIC-insured savings account,” says Gray. “Other people may normally take additional risk with their emergency fund by investing in a conservative investment structure to get a little extra return on their savings.”
Peace of mind
For people just starting out or who have had a few setbacks, you may want to take your time. As Schultz said, it can take years to bring your emergency fund to a level that guarantees you stability. And just because you don’t have an exact number that financial planners have identified as the “correct” amount does not mean that you will fail financially. As Cole says, life happens. You have to be flexible.
But if you want to aim for something, Dylan Ross, Certified Financial Planner and Coach, suggests a 1-3-6 contingency fund strategy:
- Spending one month is a good contingency fund if you have debt. Instead of increasing the size of your reserve fund, you are probably better off putting more money into paying off debt.
- A three month emergency fund is good if your only debt is a mortgage. Again, you’re probably better off filling your retirement accounts to the max and then investing extra in your mortgage than setting up an even bigger emergency fund.
- A six-month emergency fund is good if you have no debt at all. This is nice, but not necessarily at the expense of paying off the debt.
Again, these are only rough estimates. It all depends on your personal circumstances.
One last thing to consider, it’s true that you are creating this contingency fund to help yourself during a crisis, but don’t discount the peace of mind that comes with it.
“The emergency fund means they don’t go into financial position. There is a level of comfort, ”says Cole. “The cost of this level of comfort is an opportunity, but some of the opportunity cost is worth it. I have found that clients with sufficient cash reserves are not as stressed by financial events as those who do not need to lower their investment account, perhaps at a very inopportune time to finance any need that arises. “
Avoiding credit cards and loans can significantly reduce stress. And all this, in turn, means that you are really investing in the long term, as long as you do not need to spend money to pay for something else.
And this is the essence of the reserve fund. Vince, you say you have a pretty stable financial position – don’t you want to stay that way? “Having a reserve fund, even in a very boring account with low interest rates, gives you the freedom to take some risk in your investment accounts,” adds Hockenbury. “In other words, since you have an emergency account, you don’t need to sell your investment.”
Cole adds, “Do people fall in love with their money? Yes. The temptation to have too much money should be avoided. But … I’ve never heard anyone say, “I wish I didn’t have a reserve fund.”