Emergency Savings Fund: How Much Do I Need?

Often, the first step towards financial independence is establishing a proper emergency savings fund. 

While holding too much cash is detrimental to long-term wealth building—where a portion of it would be better off invested in the markets—it is wise to hold enough to provide short-term flexibility.

How Much Should I Save?

The recommended amount to hold in an emergency savings fund depends primarily on income and living expenses. 

If there are multiple reliable sources of income, three months’ worth of living expenses is typically sufficient. A classic example is a husband and wife who both work outside the home. If the family spends $100,000 per year on living expenses, they should hold $25,000 in an emergency savings account. For those with a single source of income, six months’ worth of living expenses is recommended.

Obviously, those who are more conservative can hold more cash. However, we don’t want to hold excessive amounts. Over a long period of time, cash is a poor asset to hold, as its purchasing power is eroded by inflation. Thus, we want to maintain enough cash to provide a cushion for emergencies, while investing the remainder for long-term growth.

Liquidity and Stability

Cash is king. Not in the literal sense of holding physical cash, but in terms of liquidity. An emergency savings fund should be highly liquid. It is meant for emergencies, and emergencies aren’t usually planned. Thus, avoid CDs and other illiquid investments. 

Holding illiquid securities in an emergency savings fund is like going on a boat and packing a life jacket that is inaccessible.  

Not knowing the timing of needing the funds, we also don’t want to rely on volatile assets. The last thing that we want to do is lock in losses during a down market due to an unexpected need for cash. Remember, markets can be very risky—if time isn’t on your side.

Location and Yield

When setting up the fund, I recommend keeping the account separate from everyday checking and savings accounts. The account should only be accessed in the case of emergencies such as car trouble, medical costs, or job loss.

Labeling the account “Emergency Savings Fund” can help reinforce this mental boundary. Additionally, if the account is accessed, make it a priority to rebuild it as quickly as possible.

And don’t just use any savings account to hold the cash. Yield matters. Generally, a high yield savings account or money market fund is the best place for an emergency fund. Find something with a competitive interest rate, so that it can hopefully keep pace with inflation. Shopping around interest rates, at least initially, can be one of the highest return uses of your time. It takes 20 minutes and can result in thousands of dollars of additional yield.

Considerations

Despite the financial stability an emergency fund provides, the most important element is clarity. It is freeing to know that if something unexpected happens tomorrow, you have cash to cover it. Many day-to-day financial stresses can be reduced by deliberately setting cash aside.

But what about saving for retirement or funding college for our children? An emergency savings fund should be set up before aggressively saving for retirement or other long-term goals. A little extra cash can help us avoid taking out credit card debt or dipping into retirement accounts prematurely. 

The best way to build an emergency savings fund is to take away the conscious decision. Set up automatic contributions to a separate account on a monthly basis or with each paycheck. 

Actual cash needs depend on many factors, including income, available assets, debt, and family structure. Consult with a financial planner regarding your emergency fund and other important financial decisions.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.