According to a recent study, more than 60% of people don’t have an emergency fund set-up. This isn’t good news. Having an emergency fund is an important first step before starting to build wealth.
An emergency fund is there for unexpected expenses or the loss of a job. In the case of an emergency, you won’t have to use your credit card or withdraw from your retirement fund. Instead, you’ll be able to withdraw from your emergency fund and then later replenish the account without owing any interest.
It’s also one of the first steps to take before you start putting additional savings in retirement and investment accounts. You’ll know that you won’t have to pull money back out anytime soon because you can fall back on your emergency fund. It may even help you sleep a little easier at night knowing you have some cushion to ride out any market bottoms.
How Much Emergency Fund?
An emergency fund can be used for unexpected expenses such as car repairs or medical bills. But when deciding how much to save in your emergency fund, the main thing to consider is how much you will need to cover your expenses in case you lose your job.
How much you need to have saved up depends on many things. The standard rule is to have 3 to 6 months of living expenses saved up. But this number can vary quite a bit.
Are you the sole income earner and will it take a few months to find a job? Do you have a large amount of fixed costs that will be hard to reduce? Then 6 to 12 months of living expenses is a better safety net.
On the other hand, are there expenses that you would cut back on with out a job? Or do you have a spouse that is also earning money? Then you can feel safe going with more in the 3 to 6 month range.
The best way to get an idea of the amount is to imagine losing your job tomorrow. How would you pay for your daily expenses as you look for a job? Figure out your basic expenses that will need to be covered from other funds. There may be some expenses that will be lower when unemployed such as transportation, clothing, or lunches out. And some expense may be higher, such as healthcare insurance.
And then think about what other income or accessible funds you have to cover your expenses. Will you receive severance or unemployment? Do you have a working spouse? The more back-up plans you have, the less of an emergency fund you’ll need.
How to Invest Your Emergency Fund
The best and safest way to invest your emergency fund is in a savings or money market account. Some say that it is safe to invest some of your emergency fund in the market and that over five years, it is unlikely that you’ll lose any money. But that seems to defeat the purpose of an emergency fund.
An emergency fund is there to give you the security that the money will be there when you need it and will not have fallen in value.
If you really hate the idea of having your emergency fund not earning a return then come up with the barebones amount you would need to live if you lost your job. And at least keep this amount in a money market. Then consider investing the remainder of the emergency fund in a short-term to intermediate-term bond fund and a smaller amount in a broad-based index fund such as the S&P 500.