There are many people out there, including Financial Gurus like Dave Ramsey and a lot of different Financial Blogs, that advocate the need of an emergency fund. But how much do we really need? And do we need an emergency fund at all?
Well it all depends on what your living expenses are and what you are bringing home now. If you are making next to nothing and living paycheck to paycheck then you absolutely need an emergency fund. If you are making decent money and living within your means then you don’t need to worry as much. That doesn’t mean, however, that you don’t need an emergency fund.
Let’s look at the stats and what people are saying.
Based on the level of unemployment we had a few years ago and the state of the jobs market, many financial experts upped the amount they said was needed for an emergency fund from three to six months of living expenses to nine months to a full year.
That’s a lot of money to put away for a rainy day!
Based on my expenses alone, including food and gas estimates, that would put a year’s worth at just over $40,000! That’s a lot of money to put away in a savings account earning about 0.1% interest.
Now one person I agree with when it comes to how much you should have in an emergency fund is Dave Ramsey. Why? Well he is often quoted as saying to put aside three to six months of living expenses for an emergency fund. That, however, is only partially true. The initial emergency fund he advises to build is only $1,000. Why? While he wants you to build an emergency fund of three to six months expenses eventually, he wants you to pay off debt first.
This is something most people miss. What is the point of saving for a huge emergency fund when you are drowning in debt? If we use my personal expenses as an example again then 6 months living expenses would be about $20,000. That is still a lot of money! That amount of money would get me out of all of my credit card debt and our Disney Vacation Club loan leaving us with an extra $375 a month! (My current credit card debt and how I accrued it is detailed here.)
If you are practically living paycheck to paycheck then definitely start with a small emergency fund and then pay off a bunch of debt. If you have a small emergency fund while you are trying to get out of debt and an actual emergency happens, you won’t have to stop getting out of debt in order to pay for it. Otherwise three months is plenty.
So why is only 3 months ok? Let’s take a look:
For the most part, statistically speaking with the job market turning around, if you lost your job you are very likely to find a new one in three months. Of course if you are living below your means then you will have a lot more options, especially given the likelihood that you will need to take at least a small pay cut to find a new job.
Secondly, for me like many others, we are a double income home. Sure it’d be nice to need only one income, but the reality of the world we live in is that it is more and more necessary to have two incomes to actually live and be able to stay ahead. My wife and I would have never been able to buy a home if we didn’t have two incomes unless we wanted to live paycheck to paycheck, something that is absolutely not an option for us. Now say that you lose your job and your spouse’s income only takes care of 50% of your monthly expenses. That three months of living expenses is actually six months because you only need 50% to of your monthly income to cover expenses.
Thirdly, unless you are not working hard and not doing your job correctly, the actual likelihood of being laid off without being eligible for unemployment benefits is pretty low. This further reduces the need for you to use your three month emergency fund. So, like above, if your spouse is able to cover 50% of monthly expenses and even if your unemployment benefits cover only an additional 25%, the three months of living expenses in your emergency fund now becomes a full year of expenses for you!
Not bad, eh?
There are other factors that play into this as well. For example, according to Pew Research, a company that follows social trends, only 34% of family reported having an unexpected financial hardship for the year. Also, according to the research that TodayForward has done on the likelihood of actually having a financial emergency, if you have three months of living expenses in savings, your likelihood of having to use it is at 31% or about once every three years. Also, research done a few years ago by the Consumer Federation of America found that the typical unexpected financial emergency cost $2,000 or less.
So looking at statistics and the facts, three months worth of expenses is absolutely enough to take care of most, if not all, financial emergencies. As with everything though, there are always the exceptions to the rule and you should do what makes you feel comfortable and secure. One thing I always try to keep in mind, though, is that the more I put into a liquid emergency fund in a low interest savings account, the more money I lose on a potential return if I were to invest it instead.