What’s an Emergency Fund?

I feel like I’ve been neglecting my mission of spreading personal finance education on the blog. So here is my first of many personal finance posts!

I was lucky enough to have an incredible coffee meet-up yesterday that sparked the topic of where to start getting your financial household in order. Two words, my friends. Emergency. Fund.

Also referred to as a “Safety Net” or “Rainy Day Fund” an emergency fund is a checking account that is earmarked for emergencies only i.e. your car needs new tires, your fridge dies and needs to be replaced or you find yourself between jobs.

Having cash sitting in a savings account earmarked to cover the unexpected prevents the consumer from putting the expense on a credit card which could lead to the vicious cycle of taking on credit card debt and high interest rates.

Now that we’ve established the need for an emergency fund the question becomes, how much should be in this account? The answer is that it varies. Financial experts, myself included, recommend keeping between 3-6 months worth of essential expenses in this account. Examples of essential expenses include:

  • Rent/Mortgage Payment
  • Utilities
  • Cell Phone/Cable/Internet
  • Transportation Passes
  • Car Payments
  • Food (think trips to grocery store not brunches on weekends)

So what’s the magic number, is it 3 months of essential expenses of 6 months? As I mentioned, it varies and is dependent on your household and other financial obligations. Take a look below.

Single Income Household

If you fall into this category, being that you are single or married with only one partner working, it is important to have 6 months of living expenses in an emergency fund. Should something happen to the job and the income spigot turns off, there is money to cover the necessary expenses in between jobs.

If you are part of a single income household and have substantial debts (educational or consumer) the recommendation is to dial back the emergency savings to 1-3 months of essential expenses this account. The primary reason being that those dollars would be better used towards paying down loans vs. sitting in a savings account with a low interest rate.

Dual Income Household

If you are fortunate to be part of a dual income household, the argument can be made that the financial situation is more stable than that of a single income household. Given this additional stability, the recommendation is only 3 months of living expenses in the emergency fund, at a minimum. If your the dual income household also has kids, the recommendation is to have closer to 6 months of essential expenses saved in the emergency fund.

Self-Employed/Business Owner

If you fall into this category of being self-employed or a business owner, the need for an emergency fund increases in size and importance. The recommendation for self-employed owners is to have 9 months of essential expenses in their emergency fund. In the case of business owners, essential expenses also include essential business expenses like overhead and inventory. The reason for the jump from 6 months to 9 months is accounting for the variability of income when self-employed. Its important to have this cushion of cash should there be slow months of business.

Can you Have Too Much?

I’ve found working with my clients some households sleep better at night having more than the recommended amount in an emergency savings account. Often times this is because there is a pending purchase on the horizon like a car or home and the cash is earmarked for that purchase. In other cases where there is an excessive amount of cash sitting in a low-interest savings account with no upcoming financial goals, it could be cause for concern.

Similar to the single household with debt, the dollars sitting in the savings account could be better utilized. Below are a few examples of how better utilize those extra dollars:

  • Increase contributions to 401(k)
  • Open and fund a high-interest rate savings account (ex. Ally Bank)
  • Open and fund a Roth IRA or Traditional IRA (if applicable)
  • Open and fund a taxable investment account
  • Open and fund a 529 college savings account

Having a strong handle on your emergency fund with the correct level of funding is the first step towards financial empowerment. I plan to cover other personal finance topics in posts to come like budgeting, investing and understanding your company benefits. Let me know in the comments below if there are other personal finance topics you’d like to hear about!