Emergency Fund: not too much, not too little
May 27, 2022 | By Manisha Gupta
Dave Ramsey has been telling America for years on his financial radio show to keep an emergency fund that covers at least a few months of expenses. Thank you, Dave! You saved a lot of people from financial ruin with that advice. But inflation at 5-10% and interest rates on cash still close to 0%, does this still make sense? The purchasing power of cash in the bank is dwindling fast.
Short answer: yes. The rest of this article provides the long answer about how much.
Having an appropriate amount in the emergency fund can help you avoid making the following financial mistakes that are usually detrimental to your long term plan.
- Avoid selling your investments at a loss when the stock markets (or bond markets!) are down
- Avoid the high interest rates credit card debt by having access to cash
- Protect your retirement savings by having access to cash
Having cash set aside might just make you feel safe. It saves you from the emotional stress of running out of cash.
How much cash should you keep in your emergency fund?
Start by asking yourself “What could go wrong?”. The biggest concerns that come to mind are 1) job loss, 2) medical emergency, and 3) property damage. There are special circumstances, like needing to take care of loved ones. The cost of job loss is usually higher than maximum-out-of-pocket medical expenses and property insurance deductibles, so it makes sense to start by thinking about job loss. Retirees are probably more concerned about covering the out-of-pocket for insurance claims. If you store up enough cash to cover all of those risks, you might be overdoing it.
The next questions is “If the bad thing happens, what will it cost?”. We like to think of it on a monthly basis. For job loss, start by estimating your non-discretionary expenses like your mortgage/rent, bills and utilities, and insurance premiums. Then move on to your discretionary spending: food, shopping, and fun. You might cut back on dining out, entertainment, travel and shopping, but you still have to eat and have a life!
How many months do you need to cover? That depends on the type of work you do. Job loss often happens during a recession, and some jobs are more likely to get cut than others. A general rule of thumb is Dave Ramsey’s 3 months of expense, but if you work for the State, you might be able to justify 2 months, and if you work for a tech startup, maybe 6 months, for example.
For a double income family, where both the spouses have similar incomes, your risk is lower, so you might justify a smaller emergency fund. If one spouse loses a job, the other will still be able to cover the basic expenses like mortgage/rent, insurance premiums etc with his/her income and the emergency fund can be used to cover the shortfall.
This is an important exercise! Too much cash will likely reduce your long term wealth because of inflation. Too little cash puts your long term financial plans at risk.
Where to keep it?
Keep it at a separate bank, so you won’t see it everyday and be tempted to spend it on something fun (sorry). Since you are not going to use this money for day to day expenses, try earning a little bit of interest on the account. None of the major banks pay any interest on cash! Online high yield online savings accounts have been paying 0.50% to 1.50% over the past few years (currently about 0.70%). Any easy place to shop is www.bankrate.com. Pick one with no strings attached that has a website that’s easy to deal with. They are all FDIC insured and it usually takes only 30 minutes to set up an account.
Maybe nothing! Once the account is funded, you are done. The best way to start is by automatically putting a part of your paycheck every month into this account until you reach the desired balance. Once you reach the desired amount, you can stop the automatic transfers and reallocate that cash to other savings vehicles like a brokerage account. In the event that you dip into the emergency fund, the goal should be to bring it back to the required amount once the financial conditions return back to normal.
Revisit how much you want to keep in your emergency fund once per year, or when your life changes dramatically. Establishing a simple and consistent system usually works the best!
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