Understanding the Emergency Fund Part II
In our last post on this topic, we tried to establish the idea that the emergency fund was a flexible, living thing to help you deal with emergencies.
In this post, we want to address the reasons for the 6 months living expenses goal.
One of the biggest and most common financial difficulties you may face is job loss. You certainly reduce your chance of job loss by being punctual, polite, productive, knowledgeable, and having other good work habits, but even the best employee may fall victim to bad bosses, company cut backs, or economic downturns. Six months is usually enough time to find new employment (particularly at the minimum wage level), but not always.
So why not 8 or 12 or 24 months?
Emergency fund money should take no more than 24-hours to access and allow for penalty free withdrawals. These kinds of accounts are readily available, but they don’t generally earn as much interest as other types of accounts and investments. But that’s okay. Emergency funds are about taking care of your immediate needs, not your long term ones.
If you are in a particularly unstable career field, like the arts, then a 12-month emergency fund is not a bad idea, and when the economy hit a rough patch Suze Orman recommended extending that 6-month fund to 8. When the economy is doing well, you may hear financial gurus recommend as little as 3 months. But it’s important to understand that this goal is not about a point at which you can stop saving, but about balancing your savings between short-term and long-term (liquid verses investment).
Or balancing between savings and debt reduction.
If you have debts and are ready to start paying them off, you need to strike a balance between taking care of the past and taking care of the present. Dave Ramsey’s debt snowball is a pretty good approach. He encourages setting up a smaller emergency fund to help you stabilize financially before attacking old debts full force.
Once the debt is managed and the present stabilized, then it’s time to balance between now and the future. As an example, let’s say your current living expenses are $1000 per month, so your Emergency fund goal is $6000.
Between overtime, thrift, and your tax refund, you eventually make your goal. Does this mean you should stop saving? Of course not. You have plans and goals and dreams, and you will some day reach an age where you need to stop or reduce working. The 6-month line is simply to let you know that you are now reasonably stable (the present is covered) and can divert your savings to other (future) goals. An excessive amount of money in your emergency fund isn’t the worst thing that could happen to you, but it may mean you are losing out on investment revenue.
It may also give you a distorted idea of your purchasing power.
A $20,000 emergency fund, when you only spend $1,000 per month, might mean you have $14,000 that could be better invested in a small home or education to increase your earning power. Or on a smaller scale, if you had a $10,000 emergency fund, it may be wiser to pay $3500 cash for a used car than to take out a loan to pay for it. Or an excess may mean that you can afford airfare to visit your mother.
On the bleaker side, if your unemployment lasts longer than six months, the emergency fund buys you time to liquidate other assets or make other changes to help you survive longer. It is fine to take unemployment or use food stamps and other available aids to help stretch your emergency fund out longer. That’s not cheating. Once you’re employed again, you will be paying back into the system.
Ultimately the 6-month Emergency Fund goal is about creating financial balance; not too little, not too much.