Every weekend at The Money Ninja I’ll take a reader question on anything related to personal finance. If you have a question that you need answered, please ask me by leaving a comment in this post.
This weekend’s question comes from Talen C. of Boston, MA:
How much should I have in an emergency fund?
Everyone should have an emergency fund, but how much money you need in it will depend on your own circumstances. Here’s what an emergency fund is and how to calculate the right amount you need.
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What is an emergency fund?
An emergency fund is exactly how it sounds – it’s a pool of money that is meant to cover financial expenses that come from unexpected events that happen in life:
- Job loss (being laid off, getting fired, or just giving your boss the middle finger)
- Car repairs (repairing your suspension joints costs WHAT?)
- Medical or dental emergency (big ouchies)
- Home catastrophes (fire, flood, robbery)
I read a CNBC article stating that a staggering 60% of us didn’t have $1,000 saved up to cover an unexpected life event. Without enough savings, they say most people are instead putting those surprise expenses on their credit cards or taking out personal loans that charge high interest rates. Yikes.
Then there’s this Bankrate infographic that says of those who experienced an unexpected expense in the last year, over 80% had one that costed $1,000 or more. A shocking 36% of them had an emergency situation that was over $5,000!
It goes to say that not having a rainy day fund will mean you’ll be forced to borrow money at high interest rates, and that’s not The Money Ninja way. We want people to be properly prepared and ready for life’s many curve balls.
Why do I need an emergency fund?
Having an emergency fund provides you with 3 major benefits:
1. It provides peace of mind and reduces stress
When an unexpected emergency happens, it threatens your financial stability and causes stress. If you’ve prepared for it, you’ll have a better peace of mind knowing things will be okay – it’s just a temporary inconvenience that will eventually pass.
On the other hand, not having a safety net will cause you to constantly worry about living on the financial edge and place heavy stress on an already unpleasant situation.
2. It keeps you from making bad financial decisions
If…. no… WHEN an unexpected emergency happens, having money set aside will protect you from making bad choice. There’s so many ways to get money quickly, but none of the options are financially smart.
You can get a payday loan or use your credit card for example, but at what cost? The interest, fees, and penalties associated with borrowing money are a few of the disadvantages of not having an emergency fund.
3. It helps you from spending impulsively
Remember the last time you got that tax refund or end-of-year bonus? If you’re like most people, you probably spoiled yourself and spent it on nice things. It’s tempting to impulsively buy stuff when you get a nice big pile of cash.
If the money was put directly in your emergency fund instead, you’d be less tempted to spend it. In your mind, it’s your emergency savings and not a spending account you’d use to buy that new electronic gadget or designer leather purse (however appealing that may be)!
How much do I need in an emergency fund?
How much you’ll need depends on your circumstances. It’s not a one size fits all answer. First you need to calculate what your base expenses (I call it survival needs) are per month, taking into consideration the following:
- Housing (rent or mortgage amount)
- Car (auto insurance, gas, and maintenance)
- Food (groceries)
- Health and Dental (insurance and out-of-pocket)
- Utilities (electricity, oil, gas)
- Debt Repayment (student loans and credit cards)
Don’t include things that you’d cut from your budget if an emergency happens, for example:
The total you get after adding all those expenses up is considered your per month burn rate. Now, you need to multiply that per month rate by the number of months you’ll need and that will be the total emergency fund you’d want to have.
But how many months in that?
In a nutshell, most financial gurus recommend at least 3-6 months, but I recommend at least 6 months. If you want to be a ninja warrior all-star (I mean, you are reading this post), I would aim for 12 months. It’s a lot, I know, but you’ll thank yourself if for instance you lose your job in the middle of a bad economy. That year of not worrying about how to pay for things will be a life saver.
Where should I put my emergency fund in?
It should be held in a risk-free account and readily available at a moment’s notice.
That rules out anything involving short-term risks like buying stocks. Stocks are meant to be held as long-term investments. If your money is invested in the stock market, it could mean your money is worth 20% to 40% less when you need it the most. In the last two recessions, the stock market lost 37% in 2008 and 22% in 2002.
Even risk-free accounts like Certificate of Deposits (CDs) should be avoided since most CDs require a minimum holding period. If you take money out before that time is up, the bank will charge you an early withdrawal penalty.
The only place your emergency fund should be held in are savings accounts. One with no minimums, no fees, no nothing – but that doesn’t mean you should put it in a typical savings account with low interest rates.
Here at The Money Ninja, we’re all about maximizing your finances, even when it comes to your emergency savings. Your cash should be put in something that will earn you the most until you need it.
That’s why I recommend Western Alliance High-Yield Savings Account, a savings account with an APY that’s 11x higher than your average bank account. It offers one of the highest rates you can fine and sits at or near the top of my list of the best high-yield savings account.
The Bottom Line
Having an emergency fund is one of the first things you should take care of in your financial journey. In terms of priority, there’s only several items that should ahead of stashing away for an emergency fund:
- Credit card debt
- Personal loans
- Payday loans
That’s because those types of debts or loans usually charge you high interest rates. It would be cheaper in the long run to take care of those three things first and then focus on building up your emergency savings.
What about you? Do you have an emergency fund yet or are you thinking of starting one? How many months are you aiming for?