Having an emergency fund is probably one of the most important things you could for your financial well being. If there was a hierarchy of personal finance, it is likely on the bottom with owning life insurance as not to bankrupt your family if you were to premature predecease. However, there are just a ton of different opinions on just how much should be kept in cash.
What is the Wrong Amount to Have in an Emergency Fund?
I am not sure how much of these stories I believe but there is a shocking amount of Americans without a properly funded emergency fund:
- Two Thirds of Americans would Have Trouble Covering a $1,000 expense
- A $500 expense would put Most Americans into Debt
- Nearly Half of Americans would have Trouble with a $400 emergency
I don’t care if the real number is $400, $500 or $1,000 – if you are a working adult you should have way more than those numbers in saving. Is it easy to save? Of course not, I am not preaching from some high horse, but it is hard to take those number seriously when:
- The average cable bill is over $100/mo and over 50 million house holds have cable
- The average monthly Verizon bill was $148, higher than Sprint’s $144, AT&T’s $141, and T-Mobile’s $120 and the big 4 cover 398,000,000 Plans (although there are less Americans than that)
Although linked and studied, it isn’t whether those numbers are exact or not, there is a bigger picture. We can’t pay a $400 emergency but luckily we are covered to watch ESPN the Ocho both in and out of our house.
There is something to be said about being too safe too. According to the FDIC the average savings interest rate is pitiful:
With those payouts and inflation hovering between 2 and 4% depending on what source you want to believe there is an easy case that, yes, there can be too much cash in an emergency fund. Obviously there is a difference if you are going to be using the cash in the short term, but we are just focused on how much should be in your emergency fund.
What is the Correct Amount?
I honestly do not think there is one correct answer, but rather three separate ways to look at the puzzle.
Income Based Solution to How Much of an Emergency Fund Should I Have
The first way to answer the question of determining an appropriate amount to save in an emergency fund is to take some multiple of your gross monthly income. That number is usually 2, 3 months or 6 months. Let’s say you have an extreme emergency like a disability where you are unable to work, this number would come in handy because, mentally, it may feel like you are still working.
The Pro is that it is simple. Take your annual salary divide it by 12 and then multiple the amount of months you want to have. The con is that it may be wildly inaccurate with regard to need. Maybe you have too much because you are a saver (see above) maybe you have too little because at the current time you are running a deficit.
Expense Based Solution to How Much of an Emergency Fund Should I Have
But what about those that do not spend their entire net income nevertheless their gross? For example why should I have 3 months of gross income if I am only spending 80% of my net income (i.e. 80% of the 80% after tax income)? In those cases people may feel safer having multiple months of expenses saved. Again, the amount of months is a personal decision.
The major pro, is that multiple months will provide for a long term disability, however, there is one major flaw. Most people have zero clue what they spend. If you don’t have a SOLID grasp on your necessary expenditures then coming up with a number to have saved is a fruitless exercise. One easy way to do it would be:
- Net Income
- Minus some reasonable effective tax rate
- Minus known qualified savings
- = Monthly expenditures
It is amazing to me how many people think they spend less than they do.
Being Able to Sleep at Night – Emergency Fund
This method can be used by those that really understand their personal finances. The amount is chosen at the amount of cash that is needed if the crap hits the fan moment. To me, this is the most advanced of the calculations because someone really needs to know themselves and understand their personal situation. The pro is that by its very definition it is the optimal amount allowing someone to feel safe and sleep at night. The con, is that if not done correctly it could be disastrous. I would not recommend this method for most people.
How Did my Family Determine the Cash Necessary for its Emergency Fund?
The Wife and I went with the “being able to sleep at night” method. The amount is less than a few months income and expenses, but it still allows me to sleep and cover any quick housing emergency. I have used it a few times in the past few years, but the last time was when our air conditioning unit went – I was able to offer the AC Guy cash to get a discount. The remainder of our emergency money is held in very liquid securities.