Everyone needs an emergency fund, but building one is rarely the most exciting element of financial planning. The purpose of an emergency fund is to provide peace of mind for scenarios that require immediate cash. These are often difficult or near impossible instances to predict. A few common examples include:
Short-term disabilities and illnesses
Car accident and you need to cover the deductible
You get laid off
A loved one is in a crisis and you need to support them
However, the harsh reality is that very few people are prepared for any of these scenarios. According to Go Banking Rates, only 21% of Americans have more than $10,000 in savings and 58% having less than $1,000 in savings. And as CNBC reported, 4 out of 5 U.S. workers live paycheck to paycheck, which was especially highlighted during the most recent government shutdown.
How Large Should Your Emergency Fund Be?
The most common rule of thumb is 3-6 months of non-discretionary living expenses. These are your essential expenses to get by. For example, if you lost your job, what expenses would you still have? Most likely, these include rent/mortgage, utilities, insurance, debt payments, food, and transportation. Add those monthly expenses up and multiple by 3. If you have kids or any other dependents, then multiply that number by 6 for an extra cushion.
Another option, which is slightly more accurate, is to match the size of your emergency fund to the elimination (waiting) period on your long-term disability insurance policy. Long-term disability insurance policies pay after satisfying a waiting period of 60-360 days. So if the waiting period on your policy is 180 days then have 180 days or 6 months of living expenses saved up.
Where Should I Put my Emergency Fund?
As to where to place your emergency dollars, there are 4 basic rules that should be met:
Safe
The funds should be placed in an account that is covered under the Federal Deposit Insurance Corporation (FDIC) or NCUA (the FDIC equivalent) for Credit Unions. This means your money is safe in the event of a bank failure. Most mainstream banks these days are covered under FDIC. However, be careful with money market funds as some do not provide FDIC coverage.
Liquid
This means you should be able to access the funds within 2-3 business days without unexpected volatility. This rules out the stock market, high risk assets, and long-term bonds.
Free
Make sure the account has no monthly maintenance fees, transfer fees, inactivity fees, etc.
Yield
You should earn a competitive interest rate on your short-term savings. In today’s environment, look for a rate slightly above 2%.
A good starting place to begin your search is at Bank Rate.
The Bottom Line - An Emergency Fund Is Only One Part of Protecting Yourself
A well-constructed emergency fund is still only one piece of your overall risk management plan. Your emergency reserve is a plan for short-term risks only. It is a compliment to other insurances in your plan, not a replacement. The good news is that creating an emergency fund is the easiest part of starting your risk management strategy.
The last important consideration is to adjust your emergency fund as life changes. Very few financial planning items are intended to be set and left alone. Financial planning is dynamic and needs ongoing adjustments. That means adjusting your emergency reserve during life events e.g., promotion, home purchase, marriage, kids, relocation, etc.
Do you realize you need a more effective Emergency Fund but have been unable to make yourself build it? Reach out today to schedule a free consultation with a Certified Financial Planner in Seattle.
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