When it comes to emergency funds – one size doesn’t fit all. First, remember that emergency funds are for unforeseen expenses. If you are in debt and can’t get out, you don’t have a problem with emergency cash funds; you have a problem with budgeting.
And it’s important to have a good balance and to know how much you should have on hand. If you have too much, you won’t be earning a good return on your money because it will be sitting idle. If you have too little, you take the risk that you’ll need to sell your investments at the wrong time or, worse, take emergency cash loans.
Just because an expense only comes up once in a while doesn’t mean it’s an emergency. You only pay property tax annually, but it’s foreseeable. So are car repairs, home maintenance and most medical expenses. I say this because while you may not be able to predict exactly how much these items will run and when they’ll occur, if you look back to your checkbook over the last several years, you’ll see that every few months something comes up. You must budget for unknown but foreseeable expenses. (Read my review of You Need A Budget for a good budgeting program.)
But there are true emergencies that are not foreseeable. Your house gets flooded. Your car gets stolen. You get fired at work. Your brother-in-law moves in. These calamities are hard to predict, but when they happen you have to be able to weather the storm. (You can buy insurance to cover most of these tragedies, even unemployment mortgage insurance. But you can’t get insurance for everything. Don’t kid yourself.)
Determining how much you need for emergencies is not all that difficult. Just remember that it’s not an exact science, but do your best anyway.
The first approach is to think back over your financial life over the last 10 years. Ask yourself one question.
What was the greatest amount of money you ever had to get your hands on quickly?
If you never encountered a big problem, think about your friends and family. What was the greatest amount they ever had to access immediately? That’s one measure of what kind of emergency funds you need.
Several years ago our drainage decided to launch a stealth attack on our kitchen. Water backed up into our entire first floor, and the battle was over before it began. My wife and I had to spend about $50,000 (after the insurance payments) in order to clean up the mess and replace our kitchen. That tells me I need at least $50,000 as an emergency fund.
Of course, this is one way to gauge your emergency fund needs, but that doesn’t give you the whole picture. Ask yourself one more question.
How stable is your income?
If you’re self-employed, your income might actually be more stable than if you work for someone.
Be reasonable. When is that last time you lost your job? How long were you unemployed? Double that amount and you have your second element of emergency funds requirements.
When you think about your income, anything can happen. You COULD lose your job or your business, but how likely is it? More important, how likely is it to happen immediately? How long would it take you to replace that income?
The third, and most important element of calculating how much you need to sock away for emergency funds is your spending. If you don’t know how much it costs you to live, it will be impossible for you to really know how much you need for emergencies.
Think about the example above. If you think it’s possible that you could be unemployed (in a poor economy like our present situation) for a year, you better know what it costs you to live for a year if you want to know how much you should have stashed away.
Having said all this, you may not need an emergency fund separate from your investments and savings.
If your investments are liquid, you would be able to access those funds if something happened…right? Again…I’m not talking about using your savings to make up for poor budgeting. I’m suggesting that you can rely on your liquid savings for truly unforeseen emergencies.
Some people feel that this approach is imprudent. They argue that if you need the money and it’s in the stock market and the market is down when you need it, it would be a bad time to liquidate.
That’s true. But consider that if the chances of needing to tap into the emergency funds are low (that’s why they call it an emergency) the chances are high that your savings and investments will stay invested. Furthermore, the chances of having an emergency at a time when the market is poor are even lower.
For that reason, you may not need to keep a ton of cash in an emergency fund. Just know how much you need to have and make sure to build up that account.
How do you determine how much you need for emergencies? How do you keep it invested?