How Many Months’ Worth of Spending Do You Need in Your Emergency Fund?

Last week I was talking to Sofia Pitt from CNBC about a piece she was writing on some personal finance rules of thumb.

She asked for my thoughts on how many months’ worth of spending people should keep in their emergency fund. The general rule of thumb is 3-6 months but some personal finance experts believe it should be as high as 12 months.

My answer, as usual, is it depends.

This sounds like a cop-out but allow me to explain.

I have problems with the way most people approach their emergency funds. Most financial “emergencies” are things you can and should plan for ahead of time.

There are a number of expenses that are infrequent yet predictable. You just have to make them part of your monthly budget.

There are things like car repairs, home maintenance or healthcare expenses that you know will come up at some point. You don’t know the timing or exact amount but that you can plan for them.

The same is true of all variable expenses that don’t occur on a set schedule.

Maybe you spend more money in the summer going to the lake or amusement parks or bars or concerts or whatever. Or maybe you spend more in the winter skiing or going out to restaurants or NBA games or plays. The same applies to things like wedding gifts, Christmas gifts or vacations.

Obviously, infrequent or seasonal spending habits are not emergencies. But if you can plan ahead for these types of variable expenses that means you’re not tapping your savings that have been set aside for actual emergencies.

Let’s say you set aside $75/month in your savings account for car repairs, healthcare costs and Christmas/birthday gifts for family. That would give you $900/year for each. Some years you may spend less than that which allows you to carry it over. Other years you may spend more than that and be forced to cover the difference from elsewhere.

But even if you underestimate the amount needed for a given situation, at least it can help soften the blow when the inevitable “emergencies” hit.

Funding this stuff in advance can take the sting out of the annoyance when an unwanted expense hits. It also gives certain parts of your savings an assignment so it’s not just a huge pile of cash without a purpose. This helps avoid spending that money on non-essentials.

Essentially, funding unpredictable expenses in advance is the opposite of credit card debt.

Of course, the biggest emergency for the majority of the population is the risk of losing your job and main source of income. This is where the whole number of months worth of expenses really comes into play.

This decision comes down to a number of factors — risk tolerance, career choice, how employable you are and your other sources of funds.

The following could be used as backstops in case of an actual financial emergency:

  • Home equity line of credit
  • Taxable investments
  • A diversified income stream
  • 0% interest rate credit cards1
  • Roth IRA contributions

And if you’re slowly but surely planning ahead for infrequent expenses by putting small amounts of money into your savings account each month and building those balances you could also tap those savings in a pinch.

Some people are more comfortable than others when it comes to relying on these other sources of cash to see them through a rough patch. But understanding how much you have available in other backstops can give you a better sense of how much you need to cover from savings.

And there’s one more factor that provides a huge margin of safety for a true financial shock — a high savings rate.

One of the biggest benefits of a high savings rate is the fact that you automatically have less income to replace in an emergency or when you have a large unexpected outlay. You could simply slow your savings for a time.

Personally, I’m on the low end of emergency savings because we have a relatively high savings rate and other potential sources of cash. Others are more conservative and think I’m crazy.

This is why rules of thumb in finance are basically impossible to apply to a wide swath of the population.

Circumstances matter. How you approach the idea of a financial emergency in the first place matters. Your other financial backstops matter. And your preference for risk matters.

And the idea of saving small amounts ahead of time for future costs is a great way to soften the blow when an actual financial emergency hits.

Further Reading:
Selectively Cheap

1If you know where to look and have a solid credit score you can get a grace period of 12-15 months with 0% interest rates. You have to make sure you pay them off before that initial period is up because that’s when the high rate kicks in. We made use of a number of these cards early on in my career when my wife and I were going through fertility treatments that weren’t covered by insurance. It’s not a perfect solution but gave us some time to figure things out.