Not having an emergency fund can be one of the biggest mistakes that anyone can make when it comes to their finances.
Many people are living paycheck to paycheck spending almost everything they make and have little to no savings to tap into if something bad happens!
If your financial situation is similar to the one described above you may be setting yourself up for financial ruin or hardship if something unexpected happens.
Now you may be wondering how much money should I have tucked away in an emergency fund?
There is no one size fits all answer that works for everyone as each person has a unique financial situation and financial risks that should be factored in when figuring out how much money is needed in an emergency fund to adequately mitigate risk.
A quick rule of thumb that you can use to make sure that you are in the right range is to have 3-6 months of expenses stashed away in a liquid emergency fund that you can gain access to fairly quickly when needed.
That being said everyone should do a more in depth analysis of their own financial situation to determine how much to keep in an emergency fund. See below for an example and items that you may want to take into consideration when you determine how much to stash in an emergency fund:
Ben makes approximately $40,000 per year in net after tax earnings and spends 100% of this amount each year. Ben's fixed living expenses such as housing, transportation, food and other essential expenses make up $30,000 and he spends the remaining $10,000 on non essential items (Cable TV, various entertainment subscriptions, going out to eat at expensive restaurants frequently, purchasing the latest and greatest technology, going out to bars on the weekend and various other items).
In this case Ben has fixed living costs of around $2,500 per month that need to be paid no matter what. The remaining $10,000 of non essential expenses could be cut if he were to lose his job or get hit with a large expense such as a medical bill etc. If you use the 6 month rule of thumb Ben would want to have $15,000 in an emergency fund so that he could cover his essential living expenses in case of an emergency.
Now Ben is probably asking himself how the hell can I save $15,000 for this emergency fund if I make $40,000 per year and spend 100% of that?
There are two things that Ben can do to reach his emergency fund goal of $15,000. The first thing he can do is try and cut out the $10,000 that he spends on non essential items until he is able to save the $15,000 for the emergency fund. The second thing he can do is take on a second job or side hustle to bring in some extra cash that could be allocated to the emergency fund until he reaches the goal. The fastest way he could achieve his goal is by doing both of the items above at the same time! This will take some sacrifice and hard work for a period of time but it is well worth it.
Lets say Ben decides he only wants to cut out 50% of the non essential items and also starts a second job working 15 additional hours per week making $15 per hour. By reducing his non essential expenses by 50% percent he would save $5,000 in one year. If he took the second job also he would make an additional $11,700 per year which when combined with the expense reduction would allow him to reach his emergency fund goal in less than one year.
Now that Ben has saved the $15,000 for his emergency fund where should he store it until it is needed?
The answer to the question above depends on how much risk you are willing to take on with the emergency fund money.
In Ben's situation if he goes back to his old spending habits I would say that the best thing for him to do would be to park the money in a very conservative investment so that there is no risk in loss of principal because if he goes back to spending all the money he makes he will want to be certain that the $15,000 is their when he needs it. In Ben's case the safest place to put the money would be in an online savings account which would earn a little above 2% per year based on current interest rates with almost no risk of losing money unless the banking system fails. This would allow Ben to have peace of mind that if something bad happens he could tap into that money to cover the expense rather than take on expensive credit card debt which can charge upwards of 25% interest annually!
Now lets say Ben decides that he is going to keep the reduced spending habit which would free up an additional $5,000 per year in excess earnings that he could invest in higher risk investments such as the stock market, real estate, etc. As time goes on and Ben builds his investment portfolio and wealth he may consider moving the $15,000 in emergency funds to a higher risk investment that could offer much larger returns.
For example: Ben invested the excess $5,000 for 5 years and his investments performed well and are now worth $50,000. The need to have the $15,000 in a very safe investment earning lower returns doesn't make as much sense since he has the additional $50,000 in other investments that could be used if needed. Ben's investments would have to decrease in value by approximately 76% for him to be back at his $15,000 emergency fund goal. Since this type of sharp decline is not likely if he diversifies properly Ben can afford to put his emergency fund in a higher risk/reward investment.
The main takeaway that I want you to realize is that an adequate emergency fund is essential in order to avoid possible financial hardship if something unexpected happens.
If Ben did not have his emergency fund and he lost his job for 3 months he would most likely rack up credit card debt which could be costly as the interest rates are high. Ben also could hurt his credit if he is not able to pay his bills and they are sent to collections which could impact him down the road if he is trying to finance a purchase of a home, car etc.
With a hard work, planning almost anyone can put together an emergency fund that could potentially bail them out and help them avoid negative consequences down the road. Some people may not be able to establish an emergency fund as quickly as Ben did but the important thing is to start and do as much as you can until you reach your goal.
Disclaimer:
This article is for informational purposes only and should not be considered financial, investment, legal or accounting advice. Please consult your own advisor prior to making any financial decisions.