You know how when you get on an airplane, the emergency instructions tell you to secure your own oxygen mask first, before trying to help the people around you? Having an emergency fund is like that. You absolutely must take care of this basic safety need before you can focus on any of your other financial goals.
So let’s get started. Here’s everything you need to know about setting up a right-sized emergency fund.
How Much Money Do I Need in My Emergency Fund?
People ask me this all the time. The answer is that it depends — but there is a simple calculation you can use to figure out your ideal amount.
First, know what your emergency fund is for. It’s there to help you through unexpected hard times, such as a car accident, extended illness, or — and this is the big one — the loss of your job. Ideally, you’ll never need to use this money at all. But just in case, you’ll need enough easily accessible cash to cover your living expenses until you find a new job.
So to get your emergency fund number, your first job is to figure out how many months it would take you to get another job if you lose the one you have. If you’re working in retail and there are lots of openings in your area, it could be fast. If you have a highly specialized job or work in a field where hiring takes place in a particular season, it could be a while. Do a test job search and ask colleagues for their experiences to help you with a ballpark number.
Next, you need to determine your living expenses. To do this, go through your budget and add up all the monthly line items that you simply can’t skip out on. For example, your utilities, car payment, rent and groceries are non-negotiable. Other expenses, like clothing and eating out, don’t have to figure into this calculation, since you would immediately stop spending in those areas if you had to.
Now for the math formula:
monthly expenses X months to get a new job = your emergency fund
If you are married and/or have dependents, your numbers may vary. To find out more specifics based on your family situation, check out the Brainy Money Core Four for Personal Finance Advanced Course.
Where Should I Keep My Emergency Cash?
Your emergency fund needs to be there for you when you need it, so this is not the place to make a risky investment. After all, you don’t want to be left high and dry when you need that cash. For this reason, it’s best to keep your emergency fund in a traditional savings account or a money market account with a higher interest rate.
The advantage of these accounts is that you can withdraw the money easily at any time, too. That’s important when you find yourself suddenly swamped with an unexpected expense: With an account that lets you withdraw instantly, you’ll never have to worry about racking up credit card bills to cover your emergency.
The drawback to basic savings accounts is that they don’t earn much interest. If you really want to maximize your growth, you could consider keeping your emergency fund in CDs at your bank — just make sure that you read the fine print about any penalties for early withdrawal. You could also use a Roth IRA to double as a retirement and emergency fund, since you can take out your principal without penalty. This is somewhat risky, since you’ll be behind on your retirement if you ever have to dip into your Roth for emergencies, but for a young person, it can be a good way to get started on two goals at once.
The Bottom Line
If your personal emergency fund math is stressing you out, the best thing to do is to automate your savings. By finding ways to set aside a little bit each month, you’ll eventually reach your goal of having a financial safety net that’s ready for anything.