Chances are you’ve heard about emergency funds before. If you’ve done any research towards getting out of debt, financial freedom, or finances in general…I’m sure they were mentioned. The question is, how much of an emergency fund do you need to have saved?
There are many theories about when to set up an emergency fund, and how much you need to have saved. After reading this you will have a clear understanding of everything you need to know about emergency funds!
Emergency fund definition
Investopedia says that “An emergency fund is an account for funds set aside in case of the event of a personal financial dilemma, such as the loss of a job, a debilitating illness or a major repair to your home.”
I like to jokingly refer to emergency funds as your “oh shit” money…because when “shit hits the fan” this money will bail you out. An emergency fund is money that you will hopefully never need to tap into. As the military says “I would rather have it and not need it than need it and not have it.”
You may think an emergency fund is unnecessary, but it is beneficial specifically to cover the unknown. In the last decade, there have been two big scares where the government was going to shut down and nobody would get paid. Each time, government employees scrambled for loans and help to pay their bills and/or purchase food. This wouldn’t be the case if they had money squirreled away in an emergency fund.
No matter the reason, you may find yourself without a job, covering large medical expenses, paying for an unexpected funeral, replacing a car, or any number of unforeseen issues that an emergency fund can help you cover!
Emergency fund vs. cash reserves
Is an Emergency fund the same thing as having cash reserves? yes and no.
An emergency fund is for personal use and intended to cover expenses and emergencies that happen within your personal and family life. Cash reserves are for business use and intended to cover expenses and emergencies that happen within your business.
They are basically the same thing, but with different purposes. Emergency funds can be used as cash reserves, and cash reserves can be used for personal emergencies. I caution you to avoid commingling these accounts though. Also, you don’t want to use one to cover the other.
I maintain cash reserves for my rental properties in order to ensure that vacancies, repairs, or emergency maintenance expenses are covered. If I were to use this money for a personal emergency and then have to evict a tenant it may put me in a very difficult position.
For this reason, I suggest that you maintain cash reserves (for each property) and a separate emergency fund for personal use.
Emergency fund or pay off debt
This is a great question and I have seen a couple of different theories here. In my opinion, you should pay off debt first because it costs you more in interest than your emergency fund will earn.
I think it is wise to have enough of an emergency fund saved up to cover small issues that arise ($1000-$2000). Then you can begin paying your debt off as efficiently as possible. After the (bad) debt is paid off you can focus your efforts directly on the emergency fund.
There are many theories to this though, I put $500/paycheck in my emergency/travel fund. That way it is constantly growing, but not cutting into my ability to pay off any debt I may accrue.
I think the answer to this question lies in how long it will take to pay off debt. If you can pay off all of your debt in a few months then $1000-$2000 is probably sufficient. If you’re working towards student loans that could take years to pay off it might make sense to save 6-months worth of expenses.
The Dave Ramsey View
Dave Ramsey is kind of viewed as the father of personal finance. Maybe this isn’t true, but he has been around for a long time and helped millions of people get out of debt through his “baby steps.” There are seven steps in his plan, but here are the first three as they pertain to his emergency fund strategy.
BABY STEP 1
Save $1,000 for your starter emergency fund.
BABY STEP 2
Pay off all debt (except the house) using the debt snowball.
BABY STEP 3
Save 3–6 months of expenses in a fully funded emergency fund.
As you can see, the Dave Ramsey method is to save up $1,000, pay off all debt, and then save 3-6 months of expenses. I agree with this philosophy except that I only focus on paying down debt above 7-8% interest. I do this because I can earn above an 8% return investing in real estate, index funds (historically), or privately lending my money to other investors. My rule of thumb is that I don’t pay extra on debt if I can earn a higher return investing.
If your debt is a 3% car loan and you pay it off extra fast, every extra payment is like investing the money with a 3% return. It is easy to earn more than a 3% return, so I would rather invest it and earn more than the debt is costing me!
Here is a video about my debt vs. investment theory
The Suze Orman View
Here is an exert from a CNBC article that I found interesting. This is the Suze Orman view on saving for emergencies.
“If you’re trying to get your financial house in order, any number of experts will tell you the same thing: Build up an emergency fund of at least three to six months’ worth of living expenses.
But Suze Orman, financial expert, and former CNBC television host thinks otherwise.
“They’re idiots,” Orman said at the 2017 eMerge Americas conference, answering a question about how much to keep in your emergency fund.
Orman explained that three to six months’ worth of expenses isn’t enough to feel secure. What if you lose your job and can’t find another one for a year? What if you’re hit with an out-of-the-blue medical emergency? A million potential scenarios could drain your savings without warning, so it’s better to have at least eight to 12 months’ worth of living expenses squirreled away.”
She goes on to talk about everything that can go wrong, and how secure you need to be. I agree that things can go wrong, and you should prepare. I don’t, however, agree that you should save up 12 months of living expenses before investing. For a lot of us that could be well over $30,000 that you need to have saved before you start building capital to invest!
Think about how long it takes to save $30,000. Now imagine that you’ve finally reached your $30,000 in savings, only to realize that you have to start from scratch before you can begin investing…demoralizing.
For this reason, I think 12 months’ of living expenses are unnecessary.
Emergency fund calculator
So how much do you need to save? Well, that depends.
How much money do you need to feel secure enough to invest the rest? How long will it take you to save that amount? Do you have a stable job? Do you have a ton of debt? All of these questions are important. Ultimately, you need to save as much as it takes for you to feel comfortable investing…but no more!
Check out this cool calculator to get some recommendations for your emergency fund!
Can your emergency fund be too big?
I believe there are good debt and bad debt which means that I like to invest as much as possible, asap.
In my opinion, saving three months’ living expenses is more than plenty. Besides, if you’re building capital to invest, and something goes terribly wrong, that money can help bail you out too! That’s right, your investment capital can also act as an emergency account!
Check out the Emergency fund calculator above and let me know what you think!