Emergency Fund: How Much Do You Need?

I was the victim of a hit-and-run accident last week.

Two drivers with Maryland plates sped through Northeast D.C. like they were filming the latest sequel in The Fast & The Furious franchise. My car was sideswiped as they jockeyed for position in their race to the next traffic light.

I’m annoyed, but I’m fine.

I didn’t sustain any injuries. My car got dinged up a bit, but I should get it back from the body shop in 10 days. All I’ll need to pay is my $500 deductible.

I’m extremely fortunate I wasn’t hurt. I’m also fortunate I can make a $500 payment without it crippling my finances. Not everyone is so lucky, which brings me to the importance of having an emergency fund.

Save It for A Rainy Day

One important reason to keep cash in your financial plan is in case of an emergency. I don’t believe people get into financial trouble because they drink too many lattes or eat too many brunches out. People get into financial trouble because they can’t sustain themselves when unexpected emergencies arise.

Life throws curveballs. Cars break down (or get hit). Couples get divorced. Employees lose jobs. Family members get sick and require care. When people have enough savings and liquidity, they can get through those moments relatively unscathed. But when they don’t, they are often forced to sell investments at inopportune times.

Or worse, they might be forced to turn to loans, credit cards, or check-cashing services. And that’s how the debt spiral can start.

How to Think About an Emergency Fund

If you’ve never set up an emergency fund, don’t let my car accident be in vain. Use it as the inspiration to get started. How much do you need? As it often goes in financial planning, the answer is “it depends.” But it’s helpful to think about an emergency fund in concrete terms. Here are a few ways to do just that:

• How much is your rent or mortgage each month? Make that number your initial savings goal. Once you’ve saved the equivalent of one month’s payment, increase your goal to three, and then build it up to six months. Breaking it down makes the goals seem less daunting and more attainable.
• How much money do you spend each month? If you don’t know, take your rent/mortgage and double it. Count that as one month’s expenses, and then save that Then aim for three months’ worth. Then six months’ worth. To get a more exact number, track your expenses and repeat this exercise using an even more accurate total. 
• How much is your take-home pay each month? Target that amount as your initial savings goal.  Then aim for three months. Then six.
• Want a smaller goal to start? How much is your car insurance deductible? How about your average grocery bill? Identify those costs and try saving those amounts. Then do it again. And again.

You get the idea.

Other Times to Hold Cash

There are other good reasons to keep cash on hand. You might have big expenses coming up in the next year or two. You might want to keep extra funds on hand in the event an investment opportunity arises. You to save a little each month to cushion the blow of annually recurring expenses. You might want to maintain a buffer in case your checking account runs low.

I recommend separating those funds from your “rainy-day” fund. My girlfriend has an “emergency fund,” and an “adventure fund” she uses to save for trips and other fun. I give her a hard time about the name, but I think it’s a great idea to earmark cash buckets for separate purposes.

Where to Keep Cash

If you’re just starting out building your savings, you’re going to need to decide where to keep the money. I’m a big fan of online “high-yield” savings accounts and I use one for my own savings. I’m certainly not getting rich on it, but it pays considerably higher interest than I would get in a traditional savings or checking account at a bank, and the funds are easily accessible. I have an automatic draft set up so I can transfer money between my checking account and my online savings account almost instantly.

Bottom Line

Holding cash provokes a range of ideas and emotions in different people.

Some like having a fat savings account, while others think holding cash represents a missed opportunity.

I like to think of an emergency fund as an informal kind of insurance policy. It might cost you a little to put into place. There might be some opportunity cost along the way. You might never actually use it, but you’ll certainly be glad it’s there if you ever get into a jam.

The scariest thing about emergencies is that you almost never see them coming.