One topic that often comes up in financial planning is “How much money do I need in my Emergency Fund?” I always like to start with my definition of Emergency Fund.
An Emergency fund is money that would cover 3 to 6 months of your average expenses. If your income is in the form of a salary or pension that is stable and consistent, you can probably get by with a three month cash reserve. If you are a commission-based employee it would be wise to have an emergency fund that covers 6 months cash flow. The extra buffer will come in handy if you happen to have some lean months.
Money in your emergency fund needs to be liquid, meaning it is easily accessible. Liquid assets include checking, savings, and money market accounts. This is money that you can access quickly and easily with little or no loss of principle.
Many people consider their credit card to be their emergency fund. Let me stress this, a credit card should be a last resort in an emergency. The high interest rates and potential damage to your credit is just not worth it.
It is also unwise to consider investment accounts or home equity as emergency funds. These funds are not quickly or easily accessible and the lost principle in your home or investments might negatively impact your long term goals.
Why is it important that your cash reserve be liquid? If the furnace goes out, you need new tires, you have an emergency medical bill, or any other unexpected expense comes up, you should be able to access the money you need immediately.
If you know that you will have some large expected expenses in the next twelve months, consider putting money aside in a separate savings account to cover those expenses. This money should not come from your cash reserve; it should be in addition to it. It is best to be prepared in case an emergency should arise before you can rebuild your Emergency Fund.
The simplest answer that I can give to the question “How much money do I need in my Emergency Fund?” is this:
- Take your average monthly take home pay and multiply it by 3. That will give you your 1st savings goal for your emergency fund.
- Once you reach the 3 month goal, consider paying down debt, saving for other goals such as home ownership, retirement, college, etc.
- If you need to tap into your emergency fund, replace the funds by contributing a little bit each paycheck until you have replenished the funds.
- When you have paid off your debt and your cash flow allows it, consider increasing your emergency fund to cover 6 months expenses (especially if you have commission based income).
Creating an Emergency Fund is not rocket science, it is simple math. Having an Emergency Fund will help you to stay on track with your personal and financial goals when an emergency happens (because we all have unexpected expenses sooner or later).
If you would like to discuss your options or want some help determining how much you might want to have saved in an emergency fund please contact us and we would be happy to help you weigh your options and determine some best practices for your specific needs.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
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