The first step towards financial security is the establishment of an emergency fund. But according to the Federal Reserve’s Report on the Economic Well-being of U.S. households in 2016, “44% of adults say they either could not cover an emergency expense costing $400, or would cover it by selling something or borrowing money.”¹ This is the stuff of nightmares to a financial planner.
Having a sufficient emergency fund is essential to building financial security, as it can prevent an unexpected financial hiccup -- like the loss of a job or medical expense -- from completely derailing your financial situation. It can be the difference between remaining financially solvent or going into debt. It can be the difference between staying on track with one’s financial goals or having to pull money out of investment accounts to cover short-term needs. The list goes on and on.
How much you should set aside depends on your personal situation. Though there is no one size fits all recommendation for emergency funds, I can offer some guidelines to point you in the right direction. Let’s start with the classic “textbook” recommendation for how much people should set aside for an emergency.
The “textbook” recommendation
In my studies for the CERTIFIED FINANCIAL PLANNERTM exam, the CFP Board emphasized the importance of setting aside an emergency fund with three to six months of non-discretionary expenses.
Non-discretionary expenses are those expenses which you could not eliminate -- the bills that you will still have to pay even if you were to lose your job. Typical examples of non-discretionary expenses include food, housing costs such as rent or a mortgage, car payments, student debt, etc. Additionally, you will need to include utility bills such as electric, gas, water, and your phone bill.
By contrast, discretionary expenses are those expenses which we could forego in the event of a financial emergency. Examples include eating out at restaurants, your favorite drink at Starbucks, non-essential clothing purchases, and entertainment expenses. Monthly subscription services such as Netflix, or other similar services also fall into this category, although I know some people will say these are “absolutely essential!” If you decide that some of your “luxuries” are non-discretionary, you must ask yourself if keeping them is worth going into debt, or worth derailing a long-term plan.
Once you have reviewed all of your monthly expenses and compiled your list of non-discretionary expenses, you are now able to address how many months of non-discretionary expenses you should keep in your emergency fund. Should you keep three to six months on hand, or possibly even more? The answer to this question relies on a number of factors.
Who needs three to six months?
Young people who can easily replace their income by switching jobs can generally keep a smaller emergency fund on hand, to the tune of three to four months.
If you are married, both spouses work, and you have no children, you may also be able to get away with saving three months of nondiscretionary expenses if you can rely on one working spouse’s income to cover expenses while the other is out of work.
Who needs more?
The more specialized your job is, the longer it may take to replace it if it is lost. People in a highly specialized field may have trouble finding replacement work at the same pay level and should consider keeping more than six months of nondiscretionary expenses on hand.
If you are the sole income earner in the family and you have multiple children relying on you for their support, then it is probably a good idea to keep a minimum of six months of nondiscretionary income on hand, if not more. As any parent knows, kids are unpredictable, and an expensive trip to an emergency room is never too far out of reach. When you couple the unpredictability of kids’ expenses with the possibility of being the sole income earner out of work, the necessity of keeping a little extra in an emergency fund is clear.
We never know when a serious medical event will pop up, so it is wise to have your deductible covered in your emergency fund. This has become even more important with the increasing usage of High Deductible Health Plans.
I recommend taking a look at your healthcare plan to see what your annual deductible per person is, and your maximum out-of-pocket per individual is. If you are married and/or have children, then you should also review your family deductible and your out-of-pocket per family maximum. Although it is unlikely that you will hit your out-of-pocket maximums in a given year, a serious medical issue could easily cause it to happen.
How should I invest my emergency fund?
An emergency fund should be invested in the safest way possible -- which is likely a savings account at a reputable bank. For some investors, it may be painful to park your money in a bank account where it will earn next to nothing in interest, but remember, the purpose is to be as secure as possible. What you forfeit in returns in a bank account, you gain in security (up to $250,000 FDIC insured2).
Your emergency fund should never be invested in the stock market, nor should it be in bonds, due to the simple fact that these types of investment vehicles fluctuate in value, and there is a substantial risk of loss. If you simply cannot stomach placing your money in a bank account, the only suitable alternative for investing your emergency fund would be through a reputable money market fund.
Your first step towards financial security
Establishing an emergency fund is the first step on your path towards financial security, as it prevents subsequent financial moves from being undone by an unexpected expense. If you don’t have one, start establishing one as soon as possible, invest it in the safest way possible, and leave it alone until you really need it.