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The Elusive Right-Sized Emergency Fund

Determining an emergency savings fund level that is right for you takes a bit more thought and effort than pulling a number from a headline or rule of thumb.

Emergency funds protect against the inevitable bumps in our lives, but how much should you set aside? There are plenty of answers in the media, but none of them is right for you. Human beings tend to like certainty, even on subjective questions. Rules of thumb play a role in financial planning, but one-size-fits-all answers are bad financial advice.

A common benchmark for emergency funds is that you should have enough saved to cover three to six months of expenses. Some analysts have suggested a more modest aim of six weeks of take-home pay, though a recent study from JPMorgan Chase found that two-thirds of American households still fall short of that mark. These suggestions at least use your personal earnings and lifestyle under normal circumstances as a starting point. Recently I encountered a study from economists that did not. Instead, they offered a true one-size-fits-all suggestion: Save a minimum of $2,467.

The theory goes that this figure is roughly one month of income for a lower-income household. It is enough to serve as a one-time buffer against missing a rent payment or falling behind on student loans. Emily Gallagher, a professor at the University of Colorado and an economist for the Federal Reserve Bank of St. Louis, told MarketWatch that once someone has at least $2,467 saved, the probability of short-term financial hardship drops. Researchers found that emergencies costing hundreds of dollars are much more common than emergencies that cost thousands.

The economists who conducted the study suggested that $2,467 is an attainable and practical goal for people struggling to save at all. But what if you are not that person? Even the broader rules of thumb – a certain number of weeks or months’ worth of expenses or income – don’t offer a full picture of how much you should save. The best financial advice is always customized.

Consider the opportunity cost of setting aside money in an emergency fund. Maybe you can’t pay down high-interest-rate debt, or you can’t go out to eat so often, or you can’t max out contributions to your retirement account. Just as you can save too little for emergencies, you can also save too much, meaning you have less to invest or devote to other priorities. You should understand the trade-offs you make when deciding on a specific size of emergency fund.

While this article can’t tell you how much you should set aside for emergencies, I can suggest some questions you should consider to come to the right answer for you. (This is not meant to be an exhaustive list, so give some thought to your own circumstances and priorities.)

  • How comfortable are you with risk? Some people sleep better at night with a bigger cushion at the ready in case of the unexpected. It is OK to sacrifice financial optimization for a little extra security, but recognize that your savings account can lose value to inflation over time. Keeping more cash readily available means having less to invest for higher returns elsewhere.
  • How do you define the word “emergency”? Some emergencies are clear-cut: a burst pipe that floods your living room, a broken ankle or a lost job. Some things are also obviously not emergencies. You should not dip into your emergency funds for an unplanned vacation. But what happens if you need a new car sooner than you expected? Some people build flexibility for this sort of expense into their standard budget. For others, this would be a significant unexpected and involuntary expense. The clearer you are with yourself about how you plan to use the fund, the easier it will be to determine how much you should save.
  • How high are your insurance deductibles? If you have to deal with a significant issue with your health, your home or your car, your deductible will determine how much you need to cover before your insurance will take care of the rest. If you don’t have insurance at all, your exposure to losses is even greater, which may lead you to need to save more.
  • If you run into an expense larger than your emergency fund, what is your plan B? Can you ask family members for help? Do you have access to a preapproved credit line, such as a home equity line of credit (or HELOC), that you can draw on? Can you take a loan from a retirement plan, such as a 401(k)? Can you sell investments? Or will any excess spending end up on your credit cards? All these options have costs, but your access to them and their overall impact on your finances can vary widely.
  • What do you do for a living? Some jobs have a lot of built-in security, and some are in high demand, which would make it easy to find a new position if you needed to. Others are more inherently precarious. Where you live may also affect this question; you may be more confident of finding a new job if you live in or near a major metro area. You should also be honest with yourself about how willing you would be to take a lower-paying position if you needed to make ends meet.
  • How flexible are your monthly expenses? Some regular expenditures, such as eating out, spa treatments or shopping, are easy to cut if you need to streamline your cash flow. Others, such as student loan or mortgage payments, are more or less fixed. If you are able to reduce or eliminate many of your monthly expenses in case of an emergency, you can comfortably afford to save less.
  • What are your annual expenses, and when are they due? For instance, you may only pay real estate taxes or an insurance premium once or twice a year. But if those payments are due in the middle of another emergency, you will want to know you can cover them.
  • How many real and tangible assets do you own? You shouldn’t consider the questions above in isolation. If you own multiple properties and vehicles, all with their own insurance policies and maintenance needs, you will need a higher cash reserve in case things go wrong in multiple places at the same time.

However much you decide to save in your emergency fund, remember that the entire point is for the funds to be accessible. You should be able to get at your money relatively quickly, with little risk that it will decline in value. That means you should not invest your emergency fund in the stock market. Even certificates of deposit are not ideal if their terms are long and you face early surrender charges if you need the money before the end of the term. Look for investments with maturities of three months or less, and keep at least some of your emergency fund in money market funds or a high-yield savings account.

Like most financial planning decisions, funding an emergency account is not a one-time event. You should replenish any withdrawals, of course. But you should also revisit your savings level every few years, or if you face a major life event such as marriage, the birth of a child or a major promotion. The right level a few years ago may not be the right level for you today.

As for me, I tend to be conservative in my spending and my savings rates, which came in handy when I had to replace a car recently. My emergency fund level might be too high, but I can add that to my list of financials sins.

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