If you are working, living, loving, and earning, then you need an emergency fund to help you through life’s lumps, bumps, and bruises. Think: a leaky roof, a layoff, a blown gasket, and/or a medical emergency.
For the record, an emergency fund is an account that’s earmarked for spending on urgent, unplanned situations only. By the way, a new pair of shoes, a shiny gadget, or your favorite steak dinner at a four-star restaurant is not an emergency.
It is best practice to keep your emergency funds in savings accounts or money market accounts so that you have easy access to your funds. Emergency funds can also be warehoused in checking accounts. However, if you have problems with self-control, do not keep your emergency funds in a checking account. Instead, opt for opening an emergency fund in a bank across town or via an online bank that disburses funds after 2-3 days. It will keep you honest.
How Big Should My Emergency Fund Be?
There is no consensus in the personal finance world about this topic. Some say that you should save anywhere between 6 months and 12 months of living expenses. Other pundits believe that you should have between six and twelve months of your net income.
With the former, you just need to calculate your cost of living, which in theory, should total less than your monthly income. On the other hand, the latter means that you have to stash away more because you are fully replacing your monthly take-home, not your monthly expenses.
Both make sense. Here are some factors to help you consider how big your emergency fund should be.
Six months of living expenses or net income: If you are living in an expensive city, this is a bare minimum to hold you over in the event of a job loss, a medical expense, or any other unforeseen emergency. Keeping this amount of money will keep you from relying on credit cards, which could transform a financial emergency into a financial disaster. In other words, this emergency fund saves you from going into debt.
Nine to twelve months of living expenses or net income: It would be wise to save this amount of cushion if you are self-employed, your income fluctuates (i.e. if you rely heavily on commissioned-based transactions), or if you work in a declining industry with lots of layoffs.
Twelve months of living expenses or net income: Save this amount of money if you earn $100,000 or more. There are fewer jobs offering this salary, so your job hunt may be longer than the typical candidate that is seeking positions for more modest salaries. You also want to save this amount if your job is highly specialized as it may take more time to find a job in your field. Independent of job replacement, it would be ideal for you to save this amount in your emergency fund if you have dependents and children.
These rules of thumb provide an ideal and normative framework for personal finance and money management. When it comes to creating an emergency fund, though, the most important thing is that you start building your rainy day savings as soon as possible and keep your hands off the cash until you need it.
So, even if you can’t reach the six-month benchmark right now, don’t use that as an excuse not to start. Every little bit helps.