Figuring the Size of Your Emergency Fund

By Philip Brewer on 9 October 2007 (Updated 7 August 2011) 22 comments
Photo: Philip Brewer

The usual rule of thumb is 3 to 6 months' income. Of course that's silly--the size of your emergency fund needs to be based on your spending, not your income. But even 3 to 6 months' spending is an arbitrary figure. Here's a few tips on sizing your emergency fund.

Do you need an emergency fund?

I certainly think you do, but there are those who have different ideas.

There are some who would have you invest all your savings directly into equities. Under their plan, if you have an emergency, you just charge it on credit and then pay off the debt out of income. If necessary, you can sell equities to pay it off--but you can sell the equities at a time of your choosing. That's not an insane plan, but I'd only consider it if you have: a good job in a growing field, experience and credentials that would let you quickly find another, your expenses are low compared to your income, you have some assets, and you have access to credit.

Otherwise, you definitely need an emergency fund.

Purpose

The basic purpose of an emergency fund is to tide you over if you lose your job. Because money is fungible, the same emergency fund can cover other financial gaps--unexpected expenses, or the unexpected loss of non-job income. It's there to give you some time to make the necessary adjustments when a gap develops between income and expenses--either get your income back up or cut your expenses down to match whatever income you can manage.

Basic factor

The basic factor in the calculation is one month's minimum expenses.

If you have a budget, go through and strike out any expenses that you're confident could be postponed for a few months, if necessary (entertainment, dining out, vacation travel, new glasses, new clothes, etc.).

If you don't have a budget, make a list of:

  • Minimum monthly bills This is basically all your bills that are either necessary to live, or that you are contractually obligated to pay: rent or mortgage, utilities, car payment, other debt payments, etc. Depending on contract terms, you may have monthly bills that could be canceled on a month's notice or less--cable TV, fitness club membership, and so on. If you would cancel these in the event of a short-term financial crises, you can leave them off the list. Otherwise, include them.
  • Routine monthly expense This includes groceries, gas for the car, cost of prescriptions beyond what insurance covers, etc. You can take a minimalist approach here--assume you'll be eating lots of rice and beans--but be realistic.
  • Job-hunting expenses Be sure to include all the expenses that you'd need to support a job search--your phone bill, internet access, enough money for gas (or bus tokens) to get to job interviews, dry cleaning for interview clothing, etc.
  • Other mandatory expenses This would be tuition, taxes, insurance payments (monthly share for annual expenses), etc.

Add that up. That should give you your rock-bottom expenses for one month.

How many months?

Why is the rule of thumb three to six months? It has to do with how long it takes to find a job--and how long it would take to make the necessary adjustments if you couldn't find another job. Three months is barely enough, because it's not unusual for it to take a month or two to find a new job, even if the job market is strong. Only after around three months of looking and not finding a new job would you necessarily grasp that you're facing serious difficulty and realize that you needed to take some drastic steps to reduce your expenses. It would sure to nice then to have another three months in your emergency fund, so you have some time to make those adjustments.

As for having an even larger emergency fund, there's a trade-off with being able to invest for a higher return. Bringing the total up to, let's say, twelve months, diverts an awful lot of money away from the stock market and other long-term investments, simply as a precaution against (hopefully) unlikely catastrophes.

I'd say, start with a default value of six months, and then consider making some adjustments.

You can adjust the number of months down if you have:

  • Other income If your spouse works--and wouldn't likely become unemployed at the same time as you--then you might be able to get by with three months' expenses. Similarly, if you have investment income, a side job, an allowance, a trust fund, alimony or child support--anything that brings in cash independent of your job--you can make a similar adjustment.
  • Substantial liquid assets If you've got a tidy sum in a mutual fund or a brokerage account, then you may not need as much of an emergency fund. It has to be money that wouldn't be expensive to use--money in a 401(k), IRA, or similar tax-sheltered plan doesn't count. Assets that can't readily be turned into cash, such as real estate or a car, don't count either.

(Note: You might, instead of adjusting the number of months, reduce the size of your rock-bottom expenses by the amount you expect to make in non-job-related income. I recommend against that for two reasons. First, it makes the whole calculation dependent on an accurate estimate of your non-job income. Second, it makes the calculation brittle, in the sense that changes to your non-job income ripple through to the final number. Instead, figure the minimum monthly expenses without regard to non-job income, then just adjust the number of months. The exception would be if your non-job income is both large compared to your minimum monthly expenses and quite reliable. In that case it probably would be best to just subtract it out of your minimum monthly expenses.)

You should adjust the number of months up if you have any reason to worry that you might have trouble finding another job--if you lack credentials, for example, or your current employer is the only game in town, or you're working in a declining field.

Where to keep your emergency fund

I suggest you keep at least part of your emergency fund in your local bank. There are times when even one or two extra days to move the money could cost you a lot. With that proviso, you can consider any of the usual suspects: savings account, money market account, internet savings account, money market mutual fund. A while back I talked about stashing part of your emergency fund in treasury bills, which gives you maximum security, a good rate of return, and scheduled access to your money.

Worth having

There are only two reasons not to have an emergency fund:

  1. You're broke or in debt If you've got installment debt, the interest rate you could get on your emergency fund will almost certainly be far less than what you're paying on your debt. Even in that case, you probably want to have an emergency fund greater than zero, if only to carry you over the minor glitches like a holiday weekend delaying access to your paycheck. An emergency fund of one month's minimum expenses might be a reasonable target.
  2. You're investing for a better return If you're getting great returns in your stock portfolio, it can seem stupid to have several thousand dollars sitting around earning 4.5%. It's a matter of trade-offs--the hypothetical lost return on a few thousand dollars on the one hand, versus the value of an emergency fund that's there when you need it on the other. Up to six months' minimum expenses, I think the advantages of an emergency fund outweigh the potential lost investment return.

An emergency fund is worth having, even if your job is very secure. There are all sorts of other minor emergencies that can cause a problem for someone who doesn't have a ready source of emergency cash--a miscalculation in a check register leaving insufficient funds, a payroll error by your employer leading to an underpayment, a call from a relative trying to scrape together bail money.

An emergency fund can also be used to take advantage of opportunities, both big (a business deal you've been trying to close for weeks is suddenly available--but only if you show up with a cashier's check by 5:00 PM) and small (a chance to stock up on tomato paste at 50% off). Don't put yourself in a position where a large fraction your emergency fund is tied up in "opportunities," but don't hesitate to use it either.

You ought to have an emergency fund equal to your minimum monthly expenses times at least three months, and preferably six months, and keep it to be stashed where you can get at least a large fraction of within one business day. It's one of the basic rules of personal finance for good reasons.

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Myscha Theriault's picture

Personally, I've always thought the 3-6 months thing was a bit short. While it's fine for basic emergencies, it can really fall short for major transitions or family crisis. Good analysis of sub-issues.

Philip Brewer's picture

Once your emergency account is funded, it's time to start investing for the long-term, and those long-term investments can be tapped in the event of a major crisis. Having an emergency fund gives you some flexibility in deciding how and when to tap them.

For a planned major transition, planned savings targeted for that particular transition makes good sense.

Guest's picture

This is an awesome post - one that will help me re-evaluate the little purse I have.

Guest's picture
CF

I have a HELOC balance (8+ percent), and put any additional money into paying that down rather than building an emergency fund. The way I see it is that I'm better paying down a higher interest rate (even factoring in tax deductibility) than making 5% interest. If I needed an emergency fund, I could use the HELOC, which has plenty remaining for 5-6 months expenses. Is there any risk that I'm missing in doing this?

Philip Brewer's picture

First, you're not a alone. A lot of people are doing just the same thing, and a lot of financial advisors agree that it makes no sense to save money at 5% while borrowing money at 8%.

The reason I don't like depending on credit as as emergency fund is that it depends on the credit system continuing to function smoothly. I haven't heard of any HELOC accounts getting closed during the recent credit squeeze related to the subprime lending--but that's just the sort of thing that can happen in a credit squeeze.

With banks having trouble selling their loans and property values dropping, they could decide to just get out of the HELOC business. Short of that, they might tighten up on their credit standards--and close only the HELOCs of people who might need the money. Either way, it's likely to happen just when you need the money the most.

Guest's picture
CF

Philip, thanks for your reply. I hadn't thought of that scenario, but it brings a question to mind. In my case, I have a $40,000 balance on a HELOC with a max of $75,000. If my lender wanted out of the HELOC business, what would happen? I'm guessing they'd have to sell the loan or something, but in that process, could they drop the total credit from $75,000 down to my balance? Obviously they won't walk away from $40K, but how would they get their money, yet not allow me to still use the HELOC in case of emergency? Thanks for your input - just want to be prepared, because, as you say, the time that money becomes unavailable is generally when you need it the most.

Philip Brewer's picture

I had a credit card canceled once, when the credit card company decided to quit issuing cards to people with Illinois mailing addresses. They sent me a letter six months or so in advance that said, basically, "You can go on using your card until it expires, but you're not getting another one, and be sure to change any automatic charges before the expiry date. You can go on paying the balance according to current terms." If I'd been insane, I could have drawn on the card up to the credit limit, right up to the day it expired, but charges after that would have been declined.

The most likely scenario for a HELOC would be just to tell you that you couldn't draw on the line of credit. (As you suggest, essentially dropping the maximum down to your current balance, and then tracking the balance down as you pay off the amount owing.) They could sell the debt, but they wouldn't need to--they could just switch to simply servicing the existing debt as if it were a plain old loan and not a line of credit.

I'm sure if you read the terms of the loan you'll find that they can change the terms anyway they want and that you still have to pay the money back. (If you don't borrow any new money, you can usually pay the money back under the old terms, but you still have to pay it back.) And I'm sure the terms allow them to stop lending you new money for any reason at all.

Guest's picture
Chris W

When I was an employee, I saved about 3 months of my income and quit my job. I ran through that income quickly as I worked on establishing myself as a freelancer, plus a move to a new apartment. 6 months of income is definitely the way to go. It's a terrible feeling when you look in all your empty bank accounts and at all your maxed out credit cards and realize you have nothing to fall back on.

Guest's picture
JvW

I always thought I could use credit for an e-fund - until payroll went through a day late we got an overdraft on our bank account. So your examples really hit home!

Guest's picture
Sherry

I agree you should not start building an emergency fund if you have debt. As stated, the rates just don't make sense. But I have found it useful in making ends meet by having at least $1,000 in an emergency fund while you're paying down those installments debts.

Once the debts are taken care of, you can eliminate their minimum payments out of your calculation for the minimum monthly living expenses. So that if your cars and credit cards are paid off, your monthly expenses will lower thus lowering the amount of cash you'd need to have on hand in case of a crisis.

Our family lives on a budget of $1,950 for groceries, gas, eating out, entertainment, insurance/taxes and utilities. Currently, we do have other debts so those minimum payments add up to an additional $900. If I were to base my emergency fund on my current monthly expenses, I'd need to save and hold $17,100 for a six month reserve. BUT, if first I wiped out all debts, I would then only need about $11,700 for six months. Quite honestly, I would feel even safer with a 9-12 month fund. Obviously, I would put this in a higher yielding savings account offering near 5%.

Philip Brewer's picture

Generally, the more savings and investments you have, the more stable your household finances are. The issue is, when do you say, "That's enough in cash, now I'm going to start investing for a higher return."

If you're debt-free, then I think six months' minimum monthly expenses is about the tipping point where the higher return of investing in stocks outweighs the advantages of yet more cash in your emergency fund. Any reasonably safe, reasonably liquid investments (such as an S&P 500 index fund) could be quickly turned into cash, if it looked like you were going to exhaust your initial 6 months' of emergency cash.

Your numbers would imply an extra $6000 to $12,000 of emergency cash (for a 9 to 12 month emergency fund). If equities return an average of 5% more per year than cash, that would mean that investing everything beyond a 6-month emergency fund in an S&P 500 index fund would bring an extra $300 to $600 a year in return. That's an extra month's worth of expenses every 4 years, just from the higher return on equities!

Of course the calculation changes completely if you have some reason to suspect that you'll be relying on the emergency fund for more than 6 months. But, unless you have some specific danger in mind, I think the extra return of equities outweighs the safety of cash, once you've got six months expenses stashed away.

Guest's picture

The employment center I went to told me that it generally takes 1 month for every $10,000/year in salary to find a new job of equivalent salary. In other words, If you made $40,000/year, expect your job search to take about 4 months.

If you are in debt an emergency fund is even more important but it also needs to be kept small, but big enough to cover an appliance replacement, car repair or even a trip to the doctor. $1000 is about right but don't scoff at even $200. That is better then going into even more debt.

I like the idea that A Simple Dollar had, pump the money for a debt snowball into a savings account and have it available as an emergency fund and then pay off the debt when you have enough to retire the whole thing plus a small cushion.

Guest's picture
rstlne

My emergency fund has grown steadily and now covers 2 years of expenses, which I think may be a bit on the high side because I've never had to tap into it.

Guest's picture
Jamin

If you can't afford to save 3-6 months worth of expenses while you're paying off debt, I'd recommend using a smaller emergency fund of $1,000 - $2,000 and use it for those un-budgeted expenses like car repairs. That saves you from using your credit card for those types of expenses. I wrote about this approach in How to Manage Your Finances with a Spreadsheet.

Great article. Preparing for situations like losing a job is something we should all do.

Guest's picture
Coell

I have used ING Direct, Emigrant Direct, and HSBC Direct for my Emergency Funds in the past - earning around 5%. The one I liked most was HSBC Direct, because they give you a free ATM card, which means you have access to your money immediately, versus waiting 2-3 days for a bank-to-bank transfer or when your local branch location is open. Plus I like that you can partition your account to save for different goals - such as one folder with auto-transfer set up weekly for long-term, one folder for the next big-ticket item you're saving up for, and one for vacation.

Guest's picture
Elizabeth

I'm a single person and I keep enough for at least six months in a money market account. You never know what kind of emergency expenses can come your way, especially if you have pets.

My 14-year-old cat was recently diagnosed with renal disease. She's only at Stage 1 and doesn't need any major medical treatment yet, but I'm assuming she will. I'm making sure there is enough money to give her what she needs as her disease progresses.

FYI, I used to have pet insurance on both of my cats, but found the insurance company's vet questioned everything my vet did in an effort to get out of paying a medical claim. I've found it's better just to set aside money in my budget for potential vet bills.

Guest's picture
eMoneyLog

However an simple approach to estimate your annual expenses and then divide it by 2 also works well.

Good stuff.

Guest's picture

I believe emergency fund is counter productive for people struggling with debt. Here are my reasons http://www.mewithoutdebt.com/2009/11/feeling-broke-is-good.html

Guest's picture
Allison

I think having an emergency fund is SO important. There's now way that you can completely predict any unforeseen expenses, such as house repairs and car maintenance, etc. However, it's also incredibly important to maintain and protect your emergency fund. It doesn't make any sense to reach your savings goal of x dollars only to spend it or divert it into investments. I found this blog that has some great tips and suggestions on how to protect your emergency fund http://blog.greensherpa.com/index.php/personal-finance/3-tips-to-protect... Does anyone else have any other helpful tips?

Guest's picture
Teneshia

I agree with the reasons you should have an emergency fund, but my biggest reason is to keep the roof over your head and food, electricity and food on the table, all other expenses, except life insurance, can be deferred a couple months or eliminated, until you get gainful employment.

Three months of living expenses is a nice start, but you should work toward 6-12 months of living expenses.

And I agree that some of the money should be liquid, such as three month's worth, in a savings account. But since interest rate's are almost nil in a savings account, put the rest of the money in a higher interest baring account like a CD, treasury bond or mutual fund.

For more reasons to have a rainy day fund, check out this link, http://mytensense.com/2012/05/half-of-americans-are-wise-to-skip-retirem...

Guest's picture
Guest

Good, common-sense information, which should be taught in school beginning at the kindergarten level. Anyone remember the old adage, "save for a rainy day"? I learned this simple lesson and have never forgotten; what a good (if not pretentious) life I have had! Unfortunately, we have become a nation of want-it-get-its, and our economy has shifted to reliance on this model. Time to get back to basics: keep reminding us, your messages are timeless.

Guest's picture

We currently have a small amount of debt but we get further into debt by not having a small amount saved for unexpected expenses like car repairs and such. In addition to using extra to make extra payments on our debt, we are saving alongside towards an emergency fund so that we won't continue going into debt every time something comes up.