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How Much Money Should You Have in Your Emergency Fund
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How Much Money Should You Have in Your Emergency Fund

You have undoubtedly heard the advice that you should have an ​emergency fund to protect yourself from unanticipated events. Financial experts may differ in their money philosophies, but they pretty much agree that having cash set aside for emergencies is a necessary component of a healthy financial plan. However, it is also important to determine the right amount of cash to set aside to ensure that you do not overpad your fund with money that could be used more wisely for other purposes.

Overfunding Emergency Savings

Most people worry about underfunding their emergency savings and leaving themselves exposed. However, they should also be concerned about overfunding their savings, where extra funds sit and do not issue any returns, which can hurt you.

You Are Losing Money

Because emergency funds must be accessible, the best place to save them is in a savings account at your bank or credit union, or with an online bank, where it can earn a higher interest rate than at a brick-and-mortar institution. But even at the “higher” end, your money is still only earning around 1 percent annually. Your emergency fund, regardless of where you have it saved, doesn't outpace inflation, so you are losing money. Having more in it than you need increases your losses.

You Are Missing Out on Funding Other Financial Goals

If you have too much money tied up in your emergency fund, then you are forfeiting opportunities to take care of other important financial “to do’s” such as contributing to retirement, paying off debt, or saving for a down payment on a home. Your money will be better-utilized meeting one of those goals than over-padding your emergency savings. Why keep more than is necessary in what is essentially a cookie jar, when you could be paying off high-interest credit card debt?

Determining the Correct Fund Amount

To determine a sufficient amount of money to put away in an emergency fund, you should consider items such as an amount that you are comfortable putting away that can provide you with a sense of financial stability, your current work situation, and your financial responsibilities.

Consider What’s Recommended

Typically, it is recommended that you save somewhere between three to six months of expenses in your emergency fund. Some experts recommend as little as a few hundred dollars to get you started with a “beginner emergency fund,” and some suggest as much as a year or more of your income. In addition to considering the recommendations, keep in mind the specifics of your situation such as family size, whether you own or rent a home, the number of vehicles you lease or own, and job stability.

Treat Your Emergency Fund Like Insurance

Your emergency fund is essentially an insurance policy: You are protecting yourself if something goes wrong. So approach your emergency savings the same way you would approach covering yourself with, say, auto or life insurance. You want to select enough coverage, but you don't want to choose so much that you are wasting your money on premiums or, in this case, having your money sit around earning nothing. Just as you might skimp on certain forms of insurance you don’t think you’re likely ever to use, so too can you go a bit lower on your emergency savings if you feel your financial position is relatively secure. If three months of expenses will be sufficient in your world and you can sleep at night with that number, then don’t feel swayed to go beyond that amount.

Consider Alternatives to Overfunding Your Emergency Savings

Having savings earmarked for emergencies will prevent you from borrowing in your time of need, whether it’s via credit card or from a friend or relative, and it will also help you avoid dipping into your retirement accounts. That being said, if you do contribute to a Roth IRA, know that you can withdraw funds for medical expenses without penalties (there are also allowances for buying your first home). Be mindful that you are unplugging money from earning interest, so this should be a last resort, but certainly, one to consider before covering your emergency with debt. Keep this in mind as a backup plan if you feel tempted to overfund your emergency savings. Also know that in the event of job loss, unemployment benefits will lessen the amount you need to pull from your savings, provided you are eligible.

Your Emergency Fund Should Support Your Financial Plan

Conventional wisdom may tell you the bigger your emergency fund, the better. But recognize that in overfunding your emergency savings, you may be hurting your bottom line.

While the answer to exactly how much should be in your fund is different for each person, consider these tips to determine the right emergency fund for you and avoid crossing the line into having too much in your savings. Make sure your emergency fund is working with your overall financial plan and not against it.

Source: thebalance.com