In this article, I want to answer questions you might have about emergency funds like-
- What is an emergency fund?
- Do I really need an emergency fund?
- How much is enough in an emergency fund/ How much is too big of an emergency fund?
- What does an emergency fund cover?
- What can be in my emergency fund?
- And much more…
What is an Emergency Fund?
My definition of an emergency fund is an account with a set amount of money that is highly liquid that is held in which a “safety net” is created for financial security in times of major emergency.
I will define major in more detail later, but the short definition is huge negative life events that cut off your income.
I also define an emergency fund as one of the first building blocks to assist you to build your wealth. It is important to lay good foundations before you start to build your “house of wealth” upon it.
Are Emergency Funds Necessary/ Do I Really Need an Emergency Fund?
If you are asking “should I have an emergency fund?”. Short answer- YES!
Emergency funds not only protect you in times of major emergency but they free you up once in place to invest monies to allow your money to go to work for you to make you more money.
The best time to start a fund is when you receive your first paycheck; but if that has already passed, then the next best time to start an emergency fund is now.
What Does an Emergency Fund Cover?
The purpose of the emergency fund is to cover rent/mortgage payments, basic grocery/household needs, utilities, other loans/debt you have acquired that must be paid and can’t be covered in another way when these major emergency situations occur.
While you don’t have to take on a miser mentality when deciding needs vs wants, it is best to be honest with your calculations when you decide your numbers. Also, remember that prices go up over time so being a little generous with needs can help not be constantly having to chase the new numbers each time you evaluate.
What Should the Emergency Fund Not Be Used For?
Emergency funds should not be used for non-essential items, or even these essential items when you are not in major emergency situations.
They also should not be used as savings. They are two distinct building blocks as savings are used more for preparing for buying major purchases to borrow less (larger down payment) or not borrow at all.
Savings are also used for buying wants while emergency funds should be exclusively for most important needs in limited circumstances.
Emergency funds should be at least partly established before investing and should never be used as investing. Investing items are often items whose worth fluctuates over time (stocks, bonds, ETF’s, real estate, commodities, precious metals, etc.) These items are also usually not liquid like an emergency fund needs to be.
What Kind of Account and What Assets are in It?
My advice is cash and it should be deposited into a saving account.
The asset needs to be liquid so you can get it when it is needed. Because of inflation, you should not keep it in cash or a checking account. Though few, if any, savings accounts currently match inflation, they do allow you to get some interest to grow it while you hold it. I would also avoid CDs as there are penalties to get your money prior to maturity and they are not very liquid.
Use a no-fee saving account, which has no monthly fees, minimum amount penalty, or other charges on the account. Also, consider an online high yield account as they often pay a little better than your local brick-and-mortar banks.
Do not use retirement accounts like 401K, Traditional or Roth IRA, or SEPs. First, once you withdraw the money you cannot replace it and you lose the reason for investing in these types of instruments. Second, you usually have to pay penalties to withdraw before “retirement age” (set by the government according to date of birth).
Do not use investment tools for emergency fund sources. As I said earlier, they fluctuate too much over time or are not liquid enough. These include, but are not limited to, stocks, bonds, ETFs, commodities, precious metals/jewels/art, crypto, real estate, or other alternative investments.
How Big Should My Emergency Fund Be?
There are debates as to how many months’ worth of expenses you should have, but the most often advised is 6 months’ worth. The second most advised is 3 months, while a few more put it at 9 months, but you are growing it too big if you go beyond that and should be putting it toward investments.
Usually, you want to build the first 3 months’ worth within 1-1 ½ years. If you do not have some money to start it with, this can be accomplished by dedicating 25% of your monthly expense amount for 12 months or 20% for 15 months.
After you have the 3 months covered and want to grow to 6 months, you might consider dedicating a little less for longer, say 10% of your monthly expense amount for 30 months.
Also, remember to adjust as your monthly expenses go up. Evaluate about every year or so to see if there needs to be an adjustment to the fund’s goal.
How to Figure Monthly Expenses/ Emergency Fund Example
Sit down with about a six-month to a year worth of bills. What is your monthly mortgage/rent? What are your average utility bills per month? What loans do you have and what are their minimum payments? What are your insurance premiums? How much do you spend each month on necessary groceries and household items? Do you have any payments that are yearly or quarterly?
Let’s take Tom and Alice. They decide they want a six-month emergency fund and they sit down with their bills. After answering these questions, they realize they spend about $1000/month on necessary expenses. A three-month emergency fund would then be 3 X $1000 or $3000 and six months would be $6000
They have $500 that they were saving up to start investing soon. They decide to open a saving account with the $500 and then put $250/month for the next 10 months.
Having met the three-month first goal, they reduce their monthly contribution to $200 and begin using the $50 in some other way, maybe to either reduce their loans or starting an investment account. After 15 more months, they have their six-month emergency fund and they again sit down with their bills to see if their necessary expenses have increased or if they can now shift that $200 in another direction.
Emergency Fund Calculator
Here is an Emergency Fund Calculator I created for you to use.
Emergency Fund After Retiring
It is not any less important to have an emergency fund after retiring, and might even be more important. Often as age sets in, unforeseen ailments and illnesses can become more frequent. Maybe expenses go up because you have the time to travel, whatever it is, an emergency fund is still needed.
As a retiree, you likely are drawing only from Social Security and a retirement plan like a 401K through your former employer or an IRA. While some expenses might drop, others will rise, and keeping that safety net to cover expenses is a must.
If you still need to maintain the 6-month amount or increase/decree the amount depends on other factors. What investments have you bought in your life that are paying you monthly or quarterly (rentals, dividend stocks, royalties, etc.)? What are the sizes of other accounts like checking, savings, Health Savings Account, IRAs, CDs, etc.? What type of lifestyle do you plan to maintain after retiring?
My Key Takeaways
- Serves as a safety net for emergency situations and freedom to invest to build your wealth
- Have about 6 months work of expenses in a no-fee highly-liquid saving or money market account that is easily assessable
- Build at least 3 months worth prior to investing
- Re-evaluate your expenses over time to adjust for needs.