How Much You Should Have in an Emergency Fund
Imagine you walk into a party and you see two groups of people deep in conversation. The first group is in a spirited conversation about the latest financial trend or fad that could lead to massive profits. The second group is talking about how much to have in an emergency fund.
Which group would you join?
If I were to guess, most people would likely choose the first group. But let’s be honest, how many times is there a group of people talking about their emergency fund outside of a Dave Ramsey course. Not many.
Despite its lack of pizazz, an emergency fund one of foundational pieces of a financial plan. When people think of emergency funds, the most common thought is “3 to 6 months” of expenses in their bank. That rule is stated far and wide across countless financial articles, books, and financial guru recommendations. But who devised this seemingly arbitrary range, and is it truly a one-size-fits-all solution?
The following article dives into the details of the emergency fund but before I do I want to stress the following point:
Everyone should have an emergency fund; and in most circumstances, 3-6 months will likely be sufficient. Sure… it could be too much, or it could be too little; but it’s more than most have, and you should be proud if you have worked to establish that.
If you’re the type of person who likes to know all of the nuances, keep reading. If not, feel free to stop here.
The Origins of the Emergency Fund 3-6 Months Rule
The 3-6 months guideline didn’t just fall from the sky; it was born out of a blend of caution and practicality. There are three types of situations that lead to the importance of an emergency fund called Financial Shocks. They are:
- Income Shocks: A loss of a source of income
- Medical Shocks: Expenses arising from a medical event
- Expense Shocks: Unforeseen large expenses arising from things such as a home, auto, or other.
The 3-6 months rule of thumb mostly predicates from the average time it takes a person to find new employment (Income Shock) should they unexpectedly join the ranks of the jobless.
The Unofficial, Official “3-6 Months Rule” states that you should have enough emergency funds set aside to cover 3 to 6 months of living expenses. Living expenses are defined as those expenses that you incur to maintain your well-being. The major categories that fall under this are expenses related to putting a roof over your head, food in your belly, covering regular medical expenses, maintaining your ability to work and get around, and childcare. Debt payments fall into these categories as well as if you do not pay your debts, you could lose your ability to stay in your home or drive your car.
Building an Emergency Fund
Step 1: Determine Target Size
When actually determining an emergency fund size, there really is not a “one size fits all”. The emergency fund should be sufficient enough to cover your unforeseen expenses without being so excessive that you expose yourself to a cash drag over time.
Factors that Increase Need for Emergency Fund:
- Few Sources of Income
- Large Variable Income
- Little to No Guaranteed Income
- Debt
- Low Net Cash Flow
- Kids or Dependents
- Poor Insurance or No Insurance
- Assets that Require Maintenance (Home, Auto, etc)
- Poor Health
Factors that Decrease the Need for Emergency Fund:
- Many sources of income
- Stable Income
- High Guaranteed Income (Social Security, Pension, Annuity Payments)
- No Debt
- High Net Cash Flow
- No Kids or Dependents
- Good, Comprehensive Insurance
- Well-Maintained, or Low Capital Expenditure Assets
- Good Health
You’ll notice that the lists are mirror opposites. The presence or absence of any of these items can influence your need for an emergency fund.
Here are a few examples on how this plays out:
Example 1: Consider someone who is a self-employed contract worker whose income varies significantly month to month based on winning contracts. They have 2 children, own a home with a mortgage, and have a high-deductible health care plan.
High variable income means they could have months with income far exceeding their expenses but other months where the income isn’t enough and they will need to tap reserves. With a mortgage payment, they will still need to make payments in addition to essential expenses (food, utilities, clothing, education) even if their income drops. Additionally, a high-deductible health care plan means they could experience a large medical bill to satisfy their deductible.
Need for an Emergency Fund: High
Example 2: Consider a retired couple with a pension, and two Social Security checks covering all of their essential expenses and most of their discretionary expenses. They live in a modest, well-maintained home and do not have a mortgage. They are on Medicare with a supplement plan covering all of their medical expenses with a small out of pocket deductible.
Need for an Emergency Fund: Low
Target Emergency Fund Size Calculation
1) Begin by listing all your essential monthly expenses to calculate your Total Monthly Essential Expenses. These typically include:
Housing (rent or mortgage payments)
Utilities (electricity, water, gas, internet)
Groceries and essential household supplies
Transportation costs (car payments, gas, public transportation)
Insurance (health, car, home)
Minimum loan payments (student loans, credit cards, personal loans)
Childcare or other family-related expenses
Total these expenses to understand what you need minimally each month to live.
2) Determine Essential Expense Coverage Period based on job security, health, and family obligations. For some, the number of coverage months may be more than others. To better understand estimating this number, review the Income Shock section below.
3) Multiply your Total Monthly Essential Expenses x Essential Expense Coverage Period to come up with your Baseline Emergency Fund.
If essential expenses are $3,000 per month and you would like six months of coverage, your emergency fund target would be:
Baseline Emergency Fund = $3,000 x 6 = $18,000
4) Add known Insurance Gaps such as deductibles for health insurance or a near term expense:
Example: Your health insurance plan has a $6,000 deductible before coverage begins.
Emergency Fund = $18,000 + $6,000 = $24,000
5) Comfort level check. Make sure you are comfortable with your emergency fund target. Some people are comfortable with larger reserves, and others are able to sleep at night with the bare minimum. The goal is to have an emergency fund that reflects the realities of your situation and one that prevents you from having to tap sources that are financially harmful.
Step 2: Align Current Emergency Fund with Target Emergency Fund
Once you have determined your target emergency fund size, you’ll be in one of two camps:
- Too Much Emergency Fund: If you find yourself with too much in your Emergency Fund, the question is what you should do with it? That ultimately depends on your goals but here are a few options:
- Invest It
- Give It
- Spend It
- Not Enough Emergency Fund: If you find your emergency fund short, you need to create a plan to boost your emergency fund. Here are a few options to build up the fund:
- Dedicate any excess cash flow (bonus’, raises, etc) to emergency fund savings.
- Reduce expenses to create surplus for savings.
- Lower excess retirement savings temporarily to boost savings (don’t give up free money though unless you’re in a dire situation)
Step 3: Allocate your Emergency Fund
The three most important requirements of an emergency fund are that they are safe, liquid, and accessible.
- Safe: Free from theft or loss.
- Stable: Able to be used now or in the future at a known price.
- Liquid: Able to be converted to cash quickly, without penalties or wait periods.
While emergency funds will never drive growth in your net worth over the long run, you should be aware of what returns you are receiving and seek to maximize those within the requirements set out above. Searching for higher yielding savings accounts is an important process to go through as large cash reserves earning next to nothing is a good way to lose value to inflation over time.
Three Big Financial Shocks
Income Shock
Income shock refers to an unexpected event that causes a sudden change in an individual’s financial situation, typically resulting in a loss of income. Such shocks can arise from various sources, including job loss, significant medical expenses, or economic downturns. In the context of personal financial planning, the concept of an emergency fund is critically important as a protective buffer against income shocks.
The risk of an income shock can be influenced by education level, job stability, economic trends and more. The below to charts summarize unemployment rates by education level and duration of unemployment in weeks.
Planning Considerations:
- If you were to be laid off, how quickly could you find a new position of similar income? This is a tough one particularly for older workers or some high income workers who look for similar high income work which may be sparse.
- Do you have other sources of income from a spouse or side business?
- Is the demand of your career field growing, steady, or shrinking?
Unemployment by Education Level
Duration of Unemployment from 2004 to 2024
Medical Shocks
Medical Shocks arise from unforeseen medical expenses incurred by you or family members. Medical shocks can be significant and are one of the top reasons that people file for bankruptcy.
Planning Considerations:
- Are you generally healthy or do you have chronic illness? Do you have accident prone children?
- Have you reviewed your insurance coverage to determine what would be the worst case out of pocket expense?
- Do you understand your coverage as it related to Ambulance Services, Air Ambulance, Dental Expenses, Vision, etc?
- Know that Long-Term Care services are generally outside of traditional healthcare coverage.
Expense Shocks
Expense Shocks may not be as severe but can often be more frequent. Typically, expense shocks occur as a result of the things you own. For example, a tree breaking through the window of your home or having to replace tires on your vehicle. If you didn’t own the home or the vehicle, you would not have to incur the expense.
Of course, the risk of a possible expense should not prevent you from buying things. The purpose of this information is to be aware, and financially stable enough to absorb any expense that might arise. If a likely expense from the thing you own would sink your financial boat, you shouldn’t take it on.
Planning Considerations:
- Are the possible expenses covered by insurance in some way (home insurance, auto insurance, etc)? Do you have a high-deductible or low-deductible plan?
- What is the likely timeline of a possible expense? For example, roofs have life expectancies. If you know how old your roof is, you’ll know when you might have to replace it.