How Much Do I Need to Save in an Emergency Fund?

This is a difficult question to answer as there is no one-size-fits-all solution that would satisfy everyone. Why? Well, every person has a unique financial profile, so their requirements for an emergency fund will differ and it’s hard to plan for an emergency. Most people build an emergency fund to cover emergencies and unexpected contingencies to better protect their typical financial situation. An accident, injury, job loss, or other unexpected event can wreak havoc on an unprepared household. Having emergency funds on hand to weather the storm is a great strategy. In this article, we will take a closer look at how to use an emergency fund and how much you need to set aside. 

What is an Emergency Fund?

We’ve covered the basics in the introduction, but to be more precise, an emergency fund is money that’s kept in one or more separate bank accounts to offset an unexpected financial blow. These are not savings to make a large purchase or a nest egg that’s part of a long-term savings plan. Other services and accounts should be used for those purposes. The best way to think about an emergency fund is that it’s a safety net, it’s there to use when extreme financial pressure is being applied due to an emergency. Depending on your financial situation, it can take time to build an emergency fund. But, when the fund is in place there are some important rules to follow if you want to use it correctly. First, the funds can only be used to deal with a true emergency situation. Second, when the emergency has passed, the emergency fund must be replenished to deal with any future emergencies. Now that we’ve covered the basics, let’s take a look at how to calculate how much you will need to build your emergency fund. 

How Much Do I Need in an Emergency Fund?

This is variable, as there are different schools of thought, but most financial experts agree that the best place to start is to evaluate your monthly expenses. Your income, standard of living, and the monthly expenses are important when it comes to navigating a crisis. As a rule of thumb, many people build their emergency fund to cover 3-6 months of expenses. This can seem like a huge sum for some people, but with some careful planning and monthly saving, it is possible. If your family circumstances change, the emergency fund should be adjusted up or down to take these changes into account. Some key factors to consider are career changes, job stability, bill obligation changes, a new child, and more. To build an emergency fund follow these 3 steps:

Step 1: Estimate Costs

Every critical monthly expense should be included, such as rent or mortgage, food, transportation, debt repayments, utilities, personal expenses, and more. There are costs that can be ignored, including dining out, entertainment, vacations, and other non-essential spending habits. In a true emergency when these funds would be used, these types of expenses would be irrelevant. At the conclusion of this step, you should know exactly how much you would need to cover a month of expenses in an emergency. 

Step 2: Extrapolate as Needed

Many families live from month to month with no contingency to cover an emergency. So, for some, even having an emergency fund that could cover a month of expenses would be an advantage. But, to build a truly resilient emergency fund, it’s a better idea to save 3-6 months' worth of expenses. This is scalable and ongoing. If you have a limited capacity to save, start with a week or two, scale up to a month, and then continue. Having an emergency fund can give a family an enormous sense of achievement and financial security. 

Step 3: Create the Emergency Fund

When you examine your monthly budget, look for the excess that could be saved to create the emergency fund. If there is no excess, it’s time to look at your spending habits to see if there is money that you could be saving. Even adding a small amount to an emergency fund can build up over time. It’s important to set up a dedicated bank account for the emergency to avoid dipping into the funds to cover other expenses.

How to Choose a Bank Account for Your Emergency Fund 

A standard checking account is a poor choice, it’s far too tempting to start using the funds for bargains or other purchases that don’t constitute a true emergency. But, it’s also important to have safe and ready access to the emergency fund when you need it. This level of access to funds is known as liquidity. A saving account with instant access is highly liquid and funds tied into a 5-year real-estate investment fund are highly illiquid. It’s impossible to plan for an emergency, which means that accounts that offer high liquidity are the better option. There is a little wiggle room, perhaps you have 3 months that are easier to access and another 3 months take a month or two to access. This could be a viable option for people who want to get better rates on their emergency funds that take longer to access. 

Understanding Risk vs. Return

It’s tempting to place emergency funds in accounts that offer good returns for greater risk. But, it is possible that you could lose money and degrade the amount in the emergency fund. The risk preferences are dependent on a person’s financial situation and their tolerance for risk. Most people would wisely choose to avoid placing their emergency fund at any risk. In this case, choosing safe savings and investment products is the optimal strategy. Others may want to access higher rates with a risk compromise with a high yield saving account or similar product. Bear in mind that some accounts will limit access, the number of withdrawals and many even charge for early access. One possible compromise is a short-term CD which offers access in a month or less for a better rate. Longer term CDs could be used too to stagger the access to the emergency fund as required to earn more interest. In this way, it’s possible to release a month of emergency funds as required and get higher rates. This is known as a “ladder strategy” and it requires some planning, but it’s a safe and effective compromise between risk and return.