How much money should you keep ready for emergencies?
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Build an emergency fund, they say. Itâs one of the basic bits of personal finance advice almost every expert offers. But how much do you need in your emergency fund? As with all things personal finance, how much you should set aside for a rainy day is, well, personal.
The short answer is that you should keep as much as you might reasonably expect to need during a temporary loss of income or for a major unplanned expense. But because your emergency fund should be kept in an ultra-safe place such as a checking or savings account, itâs probably not going to be the highest-performing investment in your portfolio. So you might not want to over-fund your emergency savings.
In other words, when deciding on the size of an emergency fund, you should seek a balance between covering your risk and optimizing your return. One key to determining that balance is to calculate your emergency fund ratio.Â
Key Points
- Financial pros typically recommend setting aside three, six, or nine monthsâ worth of expenses in an emergency fund.
- Your emergency fund ratio can help you determine your available assets compared to your monthly expenses.
- Once you reach your emergency fund goal, you can work on other financial goals.
How much to save in your emergency fund: 3-6-9 rule
The basic guideline for emergency funds is to set aside enough money to cover your expenses for three, six, or nine months, depending on your needs and financial situation. Think about how long you would have to live off your savings if you lost your job, suffered an illness, or experienced some other major financial event.
If you have a higher risk tolerance, you might feel comfortable with only three months of emergency savings. This might be especially true if you have other assets, like investments or equity in your home, that you could draw on after three months. On the other hand, if youâre concerned about a long-term loss of income or financial shock, and you donât have a lot of other assets to tap, you might feel more comfortable saving up nine monthsâ worth of expenses.
Take the average!
When figuring out your monthly expenses, donât just look at last monthâs bank statements and credit card bills. Some expenses, such as auto and home insurance, are assessed once or twice a year, while utility bills are often higher in the extreme weather months. So be sure to look at the average monthly spend over the past 6 to 12 months. If you do an annual budget review (and if you donât, you probably should), you might turn to that as a source.
The easiest way to determine how much you need is to figure out your monthly expenses and multiply that by how long you want to be able to cover your costs. Letâs say you decide you need six monthsâ worth of funds to feel comfortable. If your total expensesâincluding housing, groceries, insurance, and debt paymentsâamount to $3,000 a month, you would set a goal to save $18,000 in your emergency fund.
Thereâs one more factor when deciding whether you should target three, six, or nine monthsâ expenses. Consider how your average expenses are allocated between mandatory costs (rent or mortgage payments, insurance premiums, groceries, and other things you canât avoid) and discretionary expenses (things you could live without or cut back on if required). If a high percentage of your expenses are discretionary, and you believe youâre disciplined enough to truly cut back if needed, a three-month fund might work for you.Â
Financial planners often take a formal approach to determining how much you should hold in short-term, accessible savings. The emergency fund ratio is modeled after the liquidity ratios used by stock analysts to determine a companyâs ability to pay its bills. This ratio can help you determine how prepared you are to deal with a financial shock to your household budget.
To find your emergency fund ratio:
- Add up your liquid assets. How much do you have in immediately available funds? This includes your checking and savings accounts, as well as taxable investment accounts that you can access with relative ease.
- Tally your monthly expenses. Do a deep dive into your monthly costs, separating the mandatory and discretionary items.
- Divide your total liquid assets by your mandatory expenses. Once you know those numbers, do a little math to get your ratio. For example, if you have $6,000 in your emergency fund and your monthly expenses are $3,000, your emergency fund ratio is 2.0. On the other hand, if you only have $1,000 in your account with that level of spending, your emergency fund ratio is 0.33.
The higher the ratio, the better youâre prepared to handle an emergency. Consider aiming for a ratio that equals the number of months of mandatory expenses you want your emergency fund to cover. If you want a three-month emergency fund, your ratio should be at least 3.0.
Whether you use AI or a spreadsheet, the 50-30-20 rule offers a solid starting point for budgeting your money.
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Where to find emergency money
It can take time to build an emergency fund, so you should also understand how to access other assets to hold you over when you experience a financial shock. This is especially important because an unexpected expense may arise before you reach your emergency fund goal.
Do you have income diversity?
One way to reduce your need for a bigger emergency fund is to pay attention to income diversity. Do you have secondary income from a part-time job, business, or investments? If so, that can reduce your need for a bigger emergency fund, because if you lose one source of income, you still have others to help pay the bills.
Take an inventory of other assets you can draw on in a financial pinch. They might not be part of your âofficialâ emergency fund, but they might help you weather a financial storm:
- Life insurance cash value. If you have life insurance, you might be able to take a loan against your cash value. Youâll need to repay this money later or it will reduce your death benefit, but it can be a way to access money if you need it.
- Retirement accounts. You can take out a loan against your 401(k) if your plan administrator allows it. Be sure to factor in the opportunity cost (that is, the returns that would be compounding if those funds were still in your retirement account). If you leave or lose your job, your 401(k) loan becomes immediately due. You could be levied taxes and penalties if you canât repay the loan. However, you might also be able to take a hardship withdrawal from an IRA or 401(k) without penalty.
- Home equity. A home equity loan or line of credit can help you tap into the value of your house to get through a tough time. However, this should be a last resort. If you donât make your payments, you could lose your home, resulting in an even bigger financial shock.
- The Bank of Mom & Dad. Borrowing from parents or other family members can be a great resource when youâre first starting out in the âreal world.â When youâre in college or starting your first job, you may not have had time to build up an emergency fund or save for financial opportunities. But itâs not fun to be in debt to a family member, so proceed with caution.
Learn what community resources are available locally. If you can get assistance with utilities, heating, and rent, that frees up cash for other expenses. Likewise, if you can receive food from a local pantry or other community-based program, you can reduce your need for groceries, making it easier to get through your emergency.
Finally, make a list of what you can cut first. Prioritize your expenses. If you run into trouble, whatâs the first subscription you should cut from your budget? Look at how much you eat out or spend on entertainment. In a financial emergency, these are the first expenses to cut so that you arenât drawing down your emergency assets as quickly.
What to do after reaching your emergency fund goal
Thereâs a good chance youâll have to build your emergency fund a little bit at a time. If your goal is to set aside $18,000 in an emergency fund, figure out how much you can add each month. If the answer is $500, it will take you three years to fully fund your emergency savings. However, along the way, youâll be building a fund you can draw on for car repairs, new appliances, or other emergencies.
When you get a windfall, such as a work bonus, gift, or tax refund, consider putting some of it into your emergency fund to pump it up faster. Also, consider putting secondary income toward your emergency savings goal.
Once you fill your emergency fund, you can divert the money youâve been using to build your rainy-day savings to reach other financial goals. Boost what youâre contributing to retirement, or increase what youâre allocating to pay down debt. You can also increase your insurance deductibles to reduce your monthly premiums. With a fully stocked emergency fund, you can likely handle the higher out-of-pocket expenses that come with increased deductibles.
Your emergency fund is your lifeline in tough economic times. Add up your expenses and look at your available assets. Figure out how much peace of mind you need in the event of a major financial shock, and use that to guide your target for an emergency fund.
Predatory lenders and credit card companies market themselves as available-when-you-need-it emergency funds. But the interest rates they charge can turn your temporary need into a long-term debt trap from which itâs difficult to escape.
Itâs like the old adage: An ounce of prevention is worth a pound of cure.
This article was most recently revised and updated by Miranda MarquitThis article was most recently revised and updated by Doug Ashburn
