Figuring the Size of Your Emergency Fund
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.
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.
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.
There are only two reasons not to have an emergency fund:
- 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.
- 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.