Emergency fund size – how big should it be?
Everyone who got interested in personal finance first learned about an emergency fund. This is something everyone suggests beginners should start with. And they are right, having an emergency fund is an important part of personal finance and should come before portfolio building. But what is the appropriate size of an emergency fund? 1000€? 2000€ 10 000€? This is what I will try to figure out in this article.
What is an emergency fund?
First of all, let’s clear what emergency fund actually is and why would you need to have one.
An emergency fund is a part of your savings, that you hold in easily accessible account in case something happens, that will require unplanned expenses. Maybe your car broke down, your washing machine broke down or you got fired from your job. A lot of reasons might require you to dip into your emergency fund. As long as it is an emergency, its fine to temporary take money out of it.
But do that only if it is an actual emergency, going out with friends is not an emergency. And neither is a new phone that you saw on Black Friday sale. But buying a new phone because you lost your old phone can count as an emergency.
What should you use emergency fund for?
In general, an emergency fund should be used for the following things:
- Vital things breaking down – for example, your car or your fridge.
- Health issues, especially if not planned – need to see a dentist or got into an accident? Need medicine because you got flu?
- Loss of income – simply losing your job.
- Natural disasters – things happen, they are too unpredictable, but natural disasters could cause health issues, things breaking down or make your income disappear.
Things that you should not use emergency fund for:
- Leisure activities – never use an emergency fund to go out with friends.
- Getting new or upgrading old gadget’s/appliances – if your phone is not broken, don’t upgrade it with emergency fund money. Also if your phone has cracked screen, but other than that works fine, don’t use emergency fund money to get a new one. Of course, unless your job requires looking sharp. After all, you shouldn’t use your cracked phone when meeting business clients.
- Non-vital shopping – this could be anything that you just don’t really need, but want. New shoes, new TV and so on.
Average time to find a new job:
First of all, this will depend on each individual, so there is no straight forward answer. We all live in different countries, some live in the countryside, some in big cities. Some work as store cashiers and some work as neurosurgeons. While a cashier most likely will be able to find a job in a few weeks, a more specialised professional might need a few months or even moving to another city to find a job.
Your emergency fund should account for the length needed to find a new source of income, in case your old source is gone. At the same time, it also allows you to look for better job opportunities. If you can’t pay rent next month, you will take any job you can. But if you can wait for 6 months, you can choose whatever job brings you the most opportunities. Not a lot of people can afford that. After all, 40% of Americans couldn’t even afford unplanned 400 USD according to the Board of Governors of the federal reserves system.
Suggested emergency fund size:
There is no fixed size for emergency funds, it depends on everyone’s needs and should wary for each individual. But there are a few guidelines that you can follow:
- Amount to cover at least 3 months of expenses.
- Enough to make you feel financially safe.
- Should change in size over time.
The three-month rule is not something that is set in stone, but this is a number that you will hear most often. If you want, you can have it bigger or smaller. Personally, I have an emergency budget to cover 10-month expenses. And that’s simply because that’s what makes me comfortable. This is more than enough time to find another source of income or cover most of the possible unexpected expenses. If need be, I could even buy an old car and still have money for a few more months. Of course, your emergency fund size could be smaller.
But remember, that over time your expenses will probably increase. So I recommend, to occasionally review your emergency fund and increase it if needed.
Where to keep emergency funds:
It will highly depend on where you live and what financial services are available to you. But in general, you should keep your emergency fund somewhere that you can access it without taxation and with no time constraints or penalties. It’s also important that you don’t lose your emergency fund even if end times come to financial markets.
This means, that emergency fund should not be kept in the stock market as it is too volatile and unpredictable. This also means that you should not keep your money in peer to peer loans, as it’s hard to get your money out fast and without a penalty. It’s best to keep that money in a regular bank deposit account or just straight up, holding in cash. Remember that it is important to keep this money and growing it should not be your goal. It’s nice to grow it by 1-2% yearly, but if you have to pay an extra fee to get your money out early, you might lose that 1-2% at the moment you take your money out. Try to measure if it will be worth the hassle.
Few more rules to remember about emergency funds:
It takes time to build one:
If your emergency fun is 1000€ and you can contribute only 100€ a month towards it, then it will take you 10 months to build it. Meanwhile, a 1000€ can cover only one month of your expenses. If you can try to max your contributions to emergency fund at the begging, to have it ready faster.
Always replenish it after using it:
There will be times that you will have to dip into your emergency fund, but after each time, your main priority should be to replenish it as soon as you can. Save a bit more till you replenish it. Prioritise it over investing your money elsewhere. After all, there is a reason why you did set your emergency fund size that big.