Life is full of unexpected challenges. A car breaking down, a home needing repair, or losing a job – in any of these situations, you’d need a sizable amount of money quickly. That’s why many financial advisors believe building an emergency fund is a crucial component of your financial stability. But how much do you need in an emergency fund?
How much do you need in an emergency fund?
A generally accepted rule of thumb is most people should have between three to six months of living expenses in their emergency fund. Whether you should aim for the high or low end depends on your situation. If you’re single or the only income earner in your family, you should target the higher end, and have about six months in reserves. The rationale here is simple: as the sole earner, if you lost your job, you won’t have any income coming in.
Couples who are both working can typically afford to have a little less, as there is more than one source of income. Of course this is very situational, and would depend on the relative salary of each spouse. Occupations are also a component of planning for an adequate emergency fund. If you are self-employed or work on commission, it might make sense to have more than six months saved up. In all situations, be sure to increase your emergency fund as your obligations grow and lifestyle becomes more expensive.
Where to keep emergency reserves
An emergency fund should be kept in an account that’s safe and with easy access to your money. A savings account or money market account separate from your checking account can be a good choice. Preservation of principal and liquidity are key components of your rainy day fund. Also, by keeping the money separate from your day-to-day checking account, you won’t be tempted to draw down your contingency pool.
Money market accounts usually give you more access to your money by letting your write checks and make more withdrawals per month. Savings accounts have slightly higher interest rates but they might restrict how many withdrawals you can make per month. Neither account will earn much of a return but again, this isn’t an investment as much as it is a safety cushion.
Investments like stocks or mutual funds are not good options to hold emergency cash reserves. While they have a potentially higher return, these instruments aren’t as liquid as a savings account and you are subject to greater market risk, so your balance will fluctuate as the market moves. Retirement plans are also not suitable for contingency funds because not only are they intended for use during retirement, there are often penalties for early withdrawals. Currently, if you are under 59 ½ years old, there is a 10 percent early withdrawal penalty.
Tips for building an emergency fund
If you don’t have any sort of emergency fund, this should be one of your top financial priorities. Set a goal to set aside some money every month to go into your emergency fund account. Setting up a direct deposit from your checking account to your emergency account can be a convenient way to accomplish this. Consider your whole financial picture and evaluate whether a portion of your other investments – such as 401(k) contributions – should be temporarily diverted towards building an adequate contingency pool. Also, if you ever need to tap into your emergency fund, make sure to replace that money as soon as you can.
With a little planning, you can build a sufficient emergency fund fairly quickly. Then you can focus on your other more exciting financial goals – such as saving for a down-payment or even a honeymoon.