Your emergency fund should have 3-6 months of income. Ok, I suppose if you only have 60 seconds to figure out how much cash you should be keeping on hand, this is a good start. But come on. Let’s not leave huge, important financial decisions to a rule of thumb that perfectly applies to no one.
Each person has to carefully consider the security of their income and the amount of risk they carry. This takes a bit of time. But when you are trying to decide if you need $3000 cash or $30000, it’s ok to take a few hours.
Factors to consider
- Stability of your income: Sometimes reality doesn’t pan out with perception. But some incomes are more stable than others. (guaranteed pension, social security, government work)
- Number of income streams: When you have 4 ways that income flows into your household, the less impact losing one of those will create.
- Time to replace income: Some jobs take a long time to replace. Others can be replaced in an afternoon.
- % of income spent: This is really important. If you spend 100% of your income, the moment any of that income disappears panic will set in. If you only spend 50% of your income and you have 5 streams of income, losing one might have almost no impact.
- Other assets: If you had a truly horrible emergency, what resources could you use and at what cost? Maybe it would be easy enough to pull money from your Roth IRA, so you keep less cash on hand. Maybe you have a family member who would loan or give you $10,000 if you were diagnosed with cancer and had to quite your job for treatment. Sometimes people have assets that can be tapped, and some people just don’t.
- Owning homes/condition of homes: Every home you own is a liability. Things will go wrong and you need cash to fix those. Small problems run about $1000 and big ones are often $5000. The more homes you own, the more risk you carry. Older homes often need bigger repairs but even in a new home the fridge can die. That is $800-$2000 for a new one. You need to size your emergency fund to allow for these. If you can’t afford to repair your home, you can’t afford your home. By renting you will be able to keep less cash on hand.
- Owning cars/condition of cars: A car will cost you money, to maintain and in unexpected emergencies. Buying a new bike is cheaper than new tires for my minivan. The more cars you own the more risk you carry. A used car, is often your cheapest option in the long run, but you will need more cash available for the unexpected repairs. These are generally still cheaper than a $400 a month car payment. But you don’t want a $800 repair twice a year to sink you.
- Health care: If you keep a bare bones insurance, you need more cash to cover those unexpected bills. If your coverage is very generous, even a large medical issue might only set you back $1000-$3000.
- Kids: I hate to say it, but from a purely financial perspective, kids = risk. More kids = more risk. With 5 kids at home, just trust me on this one. There will be expenses that you can hardly imagine are a possibility. Especially for those, you will want to have the cash ready.
- Other insurance: If you keep minimum insurance, you will need more cash. We don’t have full coverage on any vehicle. If we hit a deer (very real possibility) we need enough cash to buy a new car within a week. There are lots of kinds of insurance, and it can save money to skimp, but you will need more cash.
- Comfort: At the end of the day, you need enough in cash so you will sleep well at night. Maybe it costs you a bit in interest or growth. But isn’t one purpose of saving money to help you feel secure and taken care of? If having a bit extra in your checking account helps keep the anxiety down, than I think its money well spent.
Let’s look at a 2 hypothetical examples:
Case study #1: Ryan
Ryan is 23 and serving in the military. He is single with no kids and no one who looks to him for financial support. His pay is set and will continue for the next 3 years when he will have the option of reenlisting. He lives in the barracks and therefore has no rent, housing bills or maintenance. He bought a new car with cash he saved from his last deployment, but doesn’t really need it. He lives just a few blocks away from work. He has about $5000 in a Roth IRA and $15000 in his TSP account. If something horrible happened, he knows his parents would help him out. His heath care is 100% covered at every military base. His only bills are his cell phone and car insurance, which he carries full coverage.
3-6 months of salary: $6000-$12,000
Actual needed emergency fund: Maybe $3000. And I think he would be just fine.
There is one extreme. Let’s look at the other extreme.
Case Study #2: Brian and Samantha plus 3 kids
They bought a home for the most they qualified for, when they were both working. But now Sam stays home with the kids. So their mortgage is $1200, but the take home pay is $2200. They have 2 older cars. One they use for a long commute, and the other for running the kids around. Their home is older and in need of some work. Their insurance is a high deductible plan that doesn’t start offering coverage till the $5000 deductible is met. They have no dental insurance, and just liability on their cars. Brian works in commissioned sales and his income varies a lot month to month, stressing everyone out. They don’t haven’t started saving for retirement. The economy in their town is struggling and he isn’t sure the job will even be there next year. Not many other places are hiring and they are underwater with their house so can’t sell quickly or easily. Ugh, I am stressed out just making up their life. Let’s stop here before it becomes any more painful.
3-6 months of salary: $6600-13,200. About the same as Ryan.
Actual needed emergency fund: $25,000-$30,000
I know they will have a hard time coming up with that number. But to really be able to cover their risks, I think that number would help them sleep well at night. Where $30k in cash might stress Ryan out because of all the growth he would be missing out on.
By actually looking at the amount of security vs risk you have, then doing a “gut check” to see if that number feels ok, you can size your emergency fund appropriately. It takes longer than the 3-6 months method, but $3,000-$30,000 is a big gap.
What do you all think? How do you go about finding that perfect cash number?