The Right Size for Your Emergency Fund
One of the most popular pieces of financial advice is the importance of establishing an emergency fund, money that can be accessed to assist with life unexpected problems, like medical emergencies or the loss of a job. Financial advisers like Suze Orman suggest that most people have ready three to six months’ worth of expenses in “liquid” savings—easily accessed—ready to go to help cover a rainy day.
I’ve suggested breaking your emergency fund into five components, but it’s the first two components that relate directly to the nearly universal definition of the emergency fund. Having cash on hand and in liquid bank accounts will help you deal with a sudden loss of income or a significant financial need, but money kept in this manner loses value over time due to inflation. Any money kept in the emergency fund is not maximizing earning potential as other investments could be. The goal is to find the right balance between allowing your savings to earn money though compound interest or appreciation and forgoing performance for accessibility.
How do you determine how much to keep accessible? As I mentioned, many experts suggest having three to six months’ worth of expenses ready to go. That’s a wide range and not very helpful. For example, for me, that could be anywhere from $12,000 to $24,000. Here are some questions to help you determine a more personalized amount.
Start with your monthly expenses. If you already track your income and expenses somewhat accurately with software like Quicken then you have your starting point. Keep in mind that your monthly expenses for this purpose include your spending plus your debt payments. Include your electric bill, even if you pay by credit card. If you have outstanding debt, include your monthly payments for your credit card, mortgage, student loans, or any other service that applies.
Look at the stability of your income. What would you do if you lost your job? Are your skills in high demand? If so, you may find a replacement for your income quite quickly. If this is the case, you have an argument for keeping the balance of your emergency fund on the shallow end. While your personality will determine how much risk you’re willing to take, and you are taking more risk by keeping a small emergency fund. Even though you may perceive your ability to find a new job earning the same amount will allow you to find you a new job within one month, it would be beneficial to assume that forces possibly beyond your control will prevent you from doing so.
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