We see the word “emergency fund” thrown around in personal finance. Professionals usually disagree on their use and how much money we should have in one. A lot of people also disagree on where to store it (hint: not under your mattress). In this post, I am going to try to address these questions from the perspective of financial independence. Specifically, I am going to address the following questions:
- What is an emergency fund?
- What isn’t an emergency fund?
- How much money should you have in it?
- Where to keep your emergency fund?
Before diving in, I want you to understand something important. This is an opinion post. Ultimately, your definition of “emergency” will differ from mine. I follow a very strict set of guidelines for my emergency fund, but it doesn’t mean you have to. With that, let’s dive in!
Emergency Fund Basics
What is an emergency fund?
According to Investopedia, an emergency fund is defined as the following:
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. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to draw from high interest debt options, such as credit cards or unsecured loans.
This is the definition that I agree with most – it does have some flaws, however. To me, its primary purpose is to cover your most basic needs in the event of a job loss. Your most basic expenses include things like mortgage/rent, medical expenses, utilities, food, and monthly bills that you must meet in order to avoid penalties.
A secondary purpose of the emergency fund is to fund major unforeseen expenses. Unforeseen medical expenses usually fall into this category. Some examples are broken/fractured bones due to injury, newly diagnosed illnesses, or other similar things. In my opinion, a hit to your health is always considered an emergency.
What isn’t an emergency fund?
There is a good rule of thumb to follow when deciding whether or not to use your emergency fund for an expense. Always ask yourself the question, “is this an emergency, or not?” before using it. Using the definition provided above, let’s look at common events that might prompt you to use this fund when you shouldn’t.
A lot of people use their emergency fund as a down payment on a house. I am a firmly against this practice. In doing this, you are setting yourself to not be able to handle true emergencies. What happens if you lose your job a month into your new house? What happens if you become injured? In these scenarios, you are required to use credit cards or other forms of debt.
Buying or repairing your car is usually not considered an emergency. This might sound a bit harsh, but these are things that you should budget for. The cost of owning a car includes maintenance and repairs. Very few cases call for using your emergency fund. It might be silly to blanket statement this, though. My advice is to just your sound judgement in this scenario.
In general, emergency funds are not a typical savings account. You should not use them to make purchases that you can properly save for.
How much money to keep in emergency fund?
Unfortunately, this is one of the areas that is least clear. I hear different numbers get thrown around all the time. It is very common for people to generalize the answer across the board. A rule of thumb often heard is 3-6 months of expenses. Some even say 6-12 months.
The truth here is that this amount varies from situation to situation. Some situations only call for 3 months, while others call for a full 12 months. When it comes down to it, there are some factors that help determine how much money to keep in an emergency fund.
Don’t forget the primary use case of emergency funds. With that, you need to consider how employable you are when determining how much money to keep in your emergency fund. Are your skills highly employable? Is the job market in your area hot? If so, you can most likely err towards a 3-6 month emergency fund.
This is a tough one. Basically, the younger you are, the less prone you are to major medical expenses. This does not mean that you are in the clear, though. The older you get, the better prepared you should be for a medical emergency.
If you are a single woman or man, then you only have to worry about your particular emergencies. The larger your family grows, the less risk you might be willing to take on. As you add kids to the picture, you will want to move from the 3-6 month range to the 6-12 month range.
Let me provide two examples of how this looks in practice.
Currently, I am married and in my early-mid 20’s. My wife is in her early 20’s. We have no kids, are relatively healthy, and are very employable. I have a computer science degree and she has a business degree. Her salary alone could cover our most basic needs. My salary alone can allow us to live a good life. With that, we decided that we want no more than 3 months of expenses in our emergency fund.
John and Jane Doe are married and in their mid 40’s. They are married, have 2 kids, a mortgage, and are also relatively healthy. Jane has a highly employable set of skills with a masters degree. She knows she could get hired anywhere in her market. John, unfortunately, does not have as employable set of skills. It would take him a 2-3 months to secure another job if he lost his. Jane’s salary is not enough to cover the family’s basic needs. John’s salary is not enough to cover basic needs. Lastly, Jane and John have no debt.
Given all of the above, it makes more sense for Jane and John to have 9-12 months of expenses in an emergency fund. If they did not have kids, they could probably get by with 6 months. If either salary was enough to sustain basic needs alone, they could get by with 6 months.
As you can see, this clearly more of an art than a science. You need to understand your situation before determining how much to have in your emergency fund.
Where to keep your emergency fund?
There is much debate about where to keep an emergency fund. Some people believe in investing it, while others would rather store the cash under their mattress. Below, I’ll outline some options for you.
High Interest Savings Account
This is where I keep mine. Interest are on the rise, so this option is looking better and better. Here, you can find some of the best online savings accounts. I use Ally, and have been very satisfied with them.
If you want additional yield with less liquidity, a CD could be for you. While I would not store my entire emergency fund in a CD, it can make sense for someone to store a portion there. Online banks, local banks, and credit unions all should have this option. Make sure you understand your liquidity options and any early access fees you might be liable to pay.
I am getting a bit fancy here. I personally wouldn’t store my emergency fund in treasury bills. However, I figured some might have an interest in it. Treasury bills are commonly used for larger sums of money. To learn more about treasury bills, visit the official treasury direct website. Some brokers also allow the purchase of treasury bills – Vanguard currently does this.
Roth IRA Index Funds/Stocks/Bonds
I actually like this option. This is considered liquid since Roth IRAs allow you to withdraw all contributions after 5 years of opening the account. If you are willing to subject yourself to short term market swings, then this option is fine. This option also works for those who keep 12 month emergency funds.
Under Your Mattress
Please don’t do this, actually. Inflation will destroy the value of your money this way. If FDIC fails you and the market goes to zero, your paper money will probably have no value.
Many other viable options also exist here. I mainly highlighted the options that I understand best. Additionally, I urge you to do some research into what your best option is for your emergency fund.
I hope you have a better understanding of emergency funds. If you do not have an emergency fund, I recommend starting a small one. It is extremely important to be prepared for the unexpected. Let me know if this was helpful for you in the comment section below!