We all know that an emergency fund is an essential tool in personal money management. And even newbies to personal finance can probably tell you how big an emergency fund should be — large enough to cover about three to six months of expenses.
But what if that rule of thumb is incorrect? If you have an emergency fund that is larger than you need, it could be costing you.
Here is what you need to know about figuring out the emergency fund sweet spot for your budget, and why it matters so much.
1. What Constitutes an Emergency?
The typical advice for creating an emergency fund assumes that you would need this fund in case of job loss. That's why the recommendation is to have several months of living expenses set aside, and why Suze Orman in particular suggests that you need eight month's expenses, since an average period of unemployment lasts about 32 weeks.
But generally, people who access their emergency fund need the money for an unexpected one-time expense, such as a car repair or medical emergency. This is a far cry from the kind of ongoing emergency you would be facing after a job loss — and you have much more leeway to handle such a gradual emergency creatively.
That's why it's a smart strategy to create a Plan B budget that you could institute in case you lose your job. If you know ahead of time what specific budget items could be struck from your monthly expenses, a smaller emergency fund could handle unemployment much longer than the typical advice would have you believe.
In addition, having a Plan B budget gives you options when there is a small financial setback — such has having to take a pay cut, for instance — without you having to dip into the emergency fund.
It's also unlikely that a job loss emergency will mean you are completely without a paycheck for several months. You might be able to find temporary or freelance work or draw some unemployment benefits, while also seriously reducing some of your expenses.
2. Expecting the Unexpected
So you know that you don't need a large emergency fund in case of a job loss. What about those unexpected one-time expenses? It's not possible to know exactly when your refrigerator will give up the ghost, or when you will need expensive dental surgery.
Except that it is possible to plan ahead for most unexpected expenses. According to a 2007 survey by the Pew Research Center, 34% of people experienced unexpected expenses in the previous year. These were the kinds of unexpected costs they faced:
- 34% had medical expenses,
- 24% had car expenses,
- 20% had home and housing expenses,
- 9% had life event and child expenses, and
- The remaining expenses were comprised of work, travel and vacation-related, pets, and taxes.
Each of these types of "unpredictable" expenses is actually fairly inevitable. No matter how healthy you are, it's likely that you will need some sort of medical care eventually. If you own a car or a home, you need to maintain it. Though you might not know when to expect a birth, a death, or a wedding, you do know that they will happen.
So instead of treating these sorts of situations as emergencies, it makes more sense to create a targeted budget category for any expense that might otherwise take you by surprise. For instance, you might create a car repair budget category into which you put aside $100 per month. Then when you have an "unexpected" repair, you will have money already set aside for that purpose.
3. The Cost of a Big Emergency Fund
Just because it's unlikely that you will need six months' worth of expenses set aside, and your unexpected emergencies can be mitigated with targeted budget categories, what's the harm in keeping a large emergency fund? It can feel good to have the security of a lot of cash on hand.
Unfortunately, there is a major cost for that sense of security: inflation.
The cost of inflation averages about 3% per year. Even the best high-yield savings accounts currently offer an annual interest rate of 1% or less. That means inflation is eating 2% of your emergency fund with every year that passes — and inflation, like interest, compounds. For instance, if you have $15,000 in a savings account with a 1% APR and 3% inflation, your money will only be worth $10,133.84 of today's dollars in twenty years. (If you would like to check my math, this is the inflation calculator I used.)
If you never experience a job loss and use targeted budgeting categories, it is very possible that you might not need to use your $15,000 savings account at any point during those twenty years. You could have done something much better with that money.
4. Emergency Fund Best Practices
It makes sense to always keep some money in a savings account so you can access the funds quickly, just in case. But above a certain emergency fund ceiling, a smart move is to invest extra cash that would otherwise collect dust in your emergency fund. In particular, parking that money in a low-fee mutual fund can help you grow your money, while still keeping the funds available in the event of that mythical job loss.
The question is, where should you place the ceiling for your savings account emergency fund?
It all depends on what amount of money on hand helps you sleep at night and how much you otherwise have invested. If you get twitchy without a fat savings account, and you have a good handle on your retirement and other investment accounts, there's nothing wrong with having a large emergency fund.
If on the other hand you still haven't set up your 401(k) at work (but are otherwise not in severe financial distress), then it makes more sense to keep your emergency fund ceiling relatively low while you work on building up your investments.
It's also important to note that contributions to your emergency fund should be a consistent line item in your monthly budget. Staying in the habit of always putting that money away will help you to replenish the fund after an emergency, and give you another monthly amount of investable money once you reach your emergency fund savings goal.
Too Much of a Good Thing
Saving too much is generally not the biggest problem among American workers. But those who do work to protect themselves financially might be taking their good habits a little too far when it comes to their emergency funds.
Maintaining the right size emergency fund may require a little more work on your part — from figuring out a Plan B budget to anticipating surprise expenses to figuring out how to make your money grow — but that extra work will more than pay off in your sense of financial security.