If you’re anything like most Americans, you struggle with determining what’s the best amount of money to set aside for emergencies. Let’s explore the topic and see if we can hit on anything useful for you to take away.
First of All – What’s Considered an Emergency?
OK – let’s get real. That new pair of shoes or the best new gadget that just came out isn’t an emergency! If you’re spending your emergency stash on this kind of stuff then you need to stop – that isn’t what it’s for 🙂
Here are a couple things that I would consider legitimate emergencies:
- Emergency room visit because you broke a bone
- Car accident deductible when you caused an accident
- Hot water heater stopped working
- You just got a pink slip
Notice how things like tire changes, Christmas presents, and general car repair aren’t on the list? This is because these are “plannable” events that you should be saving for along the way. They are predictable. The items on the list are not really predictable in terms of their timing – this is why we call them emergencies.
How Much Cash Should I Set Aside for an Emergency?
It depends! There are a couple different theories here that we’ll explore. We’ll start from most conservative to least conservative:
These folks have one or two years of expenses saved in cash and sitting in the bank. The advantage of this approach are that cash flow from month to month can be ignored because there is a huge pad of money. The large disadvantage here is that inflation is chipping away at their savings 2%-3% a year. I’ve fallen in this category for the past 10-years, and I’m finally coming around to realize how crazy I was to not invest a majority of my money. Please make sure you don’t find yourself in this category.
This person has a sizeable amount of debt that they’re trying to pay off. They allocate ~half to paying off their debt and ~50% to building up an emergency fund. The pro here is that they’re paying down their debt some and saving some. The con, of course, is that their debt can be 6% on up! In most cases, I’d recommend that they get more aggressive at paying off their debt and let the emergency fund wait. The worst case scenario is that something goes wrong and they just put the emergency back on credit. The best case scenario is that they pay off the debt early and save hundreds to thousands of dollars.
The Textbook Model
Anyone that falls in this category has about six months of EXPENSES saved for an emergency. This is a pretty balanced approach that gives most of the benefits with a small amount of negatives – losses due to inflation on the small pile of cash. Not that big of a deal in the big picture.
The Risk Taker
These folks believe that you should NOT really have any emergency fund in cash. Everything should be invested one way or another. If an emergency occurs, you can put it on a credit card, take out a HELOC, etc. I have a plan to eventually work myself over into this category given enough time, but I’m still mentally adjusting to the high amount of risk. My personality isn’t to sit on the bleeding edge of what’s possible by default – I have to force myself to do it 🙂
So, if you were looking for a “2+2=4” type of answer, you won’t find it here. Everyone’s situation is different, and everyone can sleep at night with a certain amount of risk they’re willing to take. There is no perfect answer for the question: “what’s the right amount for an emergency fund?” I think the “worry-warts” and the “debtors” have the most to gain from this article. If you find yourself in one of these two categories, consider the amount of money you’re losing in the long run to either inflation or additional interest payments. I believe that if you step back and look at the situation without letting your emotions get involved, you’ll see that it’s best to shift closer to the “textbook model” or the “risk taker” type of approach.