"Emergency fund" is typically taken to mean a bank account holding the funds you'd rely on in the event of a job loss or other unexpected financial hardship.
A common "rule of thumb" is 3-6 months of essential household expenses.
But holding 3-6 months of expenses in a bank account is often NOT the best approach.
To be clear, you definitely need an emergency fund, and a chunk of it should be in a bank account - as the old saying goes: "$#*! happens."
And when $#*! does happen, you definitely don't want credit cards to be your first line of defense.
But prioritizing saving 3-6 months of expenses in a bank account (even a high-yield online account) can lead to a lot of missed opportunities:
- Missed retirement savings account contributions
- Missed employer matches
- A big chunk of your savings stuck in a barely-keeps-up-with-inflation-if-you're-lucky investment
How to Size Your Emergency Fund
Sometimes, when you're thinking about sizing your emergency fund, you can talk yourself into a place where you end up feeling like you're preparing for Armageddon.
This is not a good way to plan.
I like to break "emergency fund" into "core emergency fund" and "extended emergency fund".
"Core emergency fund" is what you'd need to handle a "not too hard to imagine" downside case.
"Extended emergency fund" is what you'd need to handle a "wow, when it rains it pours" downside case. This is a bigger number and includes your core emergency fund.
To find the right number for you, consider these factors:
(a) If you (and / or your spouse) lost your job, how long would it take to find another job with comparable pay?
(b) If you (and / or your spouse) were unemployed, would you have access to meaningful supplementary income?
Consider: unemployment insurance, support from a union, help from family members (if you've not had an explicit conversation they'd be willing and able to help, I'd assume zero)
(c) Are there other factors in your life that could reasonably cause significant, unexpected expense?
Examples: a health condition, something going awry with your home or car, a close relative facing challenges.
Let's Talk Through Some Examples
"Not too hard to imagine" downside scenario
Example: If Vijay's company downsized, but Ann remained employed, and it took 2 months for Vijay to find his next opportunity as a software engineer. They have two kids to support.
"When it rains, it pours" downside scenario
Example A: Same as above, but it takes Vijay 5 months to find new employment as a software engineer.
Example B: Both Vijay and Ann lose their jobs at the same time, and it takes them 5 months to find work.
Whether A or B is the right scenario to plan for in their family comes down to their professional situations and the market for those jobs. If Ann's a tenured computer science professor, Ann & Vijay losing their jobs at the same time and taking 5 months to both find work is unrealistically severe.
If Ann is a trader (much less job stability) then they probably should contemplate a scenario where they're both unemployed. But maybe - given the high demand for software engineers - they don't need to assume 5 months.
In that "two unemployed working parents" scenario, Vijay could take the next available job, rather than holding out for something he loves. And perhaps Ann would decide that she'd "lower the bar" a bit on her ideal next opportunity in that scenario, too.
Perhaps the right "when it rains it pours" scenario for Vijay & Ann is:
Example C: Both Vijay and Ann lose their jobs around the same time. Vijay takes a job with comparable pay within 2 months, Ann takes up to 4 months to find the right role.
Finding the right "downside scenarios" to plan for with your family is really about having an open, honest discussion about what life might look like if things didn't go quite right.
To calculate your emergency fund:
# months you would need to find a comparably paid job*
[ "essential" monthly household expenses aka "stuff you couldn't quickly cut out"
- supplementary income ]
= emergency fund goal
*Consider both your "not hard to imagine" scenario and your "when it rains it pours" scenario. If you came up with less than 2 months, I'd suggest reconsidering your assumptions. Sure, if you're a software developer in NYC you can be unemployed for about as long as you want to be, but it can be helpful to give yourself a little time to be sure the next opportunity is the right one.
Think about the emergency fund goal: does it look big enough to handle what you thought of when I asked, "Are there other factors in your life that could reasonably cause significant, unexpected expense?" If not, bump it up. If yes, you're good to go!
I want to be clear: if you don't pay your credit cards in full each month, those credit card balances should be paid down to zero before you start building an emergency fund.
Now that you have your target emergency fund in mind, and an idea of what's "core" vs. "extended", let's talk about whether putting all of it in a bank account makes sense.
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