How Big Should Your Emergency Fund Be?
If you are a fan of Dave Ramsey or other financial gurus, then you know they suggest starting out with $1,000 in an emergency fund while you pay down debt. Once the debt is gone, you are to increase the size of your emergency fund to six months of living expenses. Currently, the average length of unemployment is just under 10 months. Basic math tells me that six months of expenses in an emergency fund isn’t going to cut.
Of course, you could (and should) cut back on your spending during times of unemployment to stretch that six months’ worth of money out so it lasts longer, but you need to remember two things. First, some expenses cannot be cut, like you mortgage, car payment, etc. and secondly, 10 months is only the average length of unemployment. There are people that are unemployed for much longer than that. Because of this, I recommend closer to 12 months of living expenses in an emergency fund.
Where to Stash the Cash?
When the math this done, you will realize that 12 months of expenses is a large amount of money. You will need to ask yourself, where will you keep this money? Hopefully, your answer is not “under the mattress” or “buried in the backyard”!
For most, they put their emergency fund into a savings account. When interest rates were higher, this was a great place to keep your money while keeping the principal safe from loss. This was also great when we were advised to keep six months of living expenses saved because not a large amount of money was sitting in a low interest bearing account. Now that I recommend 12 months of living expenses, we need to address where the money should reside.
Here is how I recommend divvying up you emergency fund. First, I would keep three months in a savings account. I know that interest rates are horrible right now, but this is a price to pay when you need to keep some money liquid. The rest of the money should go into either a short term bond fund or a TIPS fund. These two investment vehicles will allow your money to work for you as they both offer higher rates of returns as opposed to a savings account. You do need to understand that investing in these vehicles does not prevent you from losing principal. Let me repeat that: you can lose principal when investing in bond funds.
With that said, short term bond funds and TIP funds tend to be relatively stable over the longer term. There is very little day to day volatility in them which makes them a consideration when investing your emergency fund.
Some people may be asking why would you even invest some of your emergency fund? The reason goes back to the low interest rates of savings accounts. I’ve written before on inflation and how it eats away at your purchasing power. Investing part of your emergency fund in short term bonds allows you to stop inflation from eroding your purchasing power.
Wanna Be Bold?
For other readers that are more aggressive with their money, I offer this solution: put the entire emergency fund into short term bond funds. If you have a high credit line, you can easily use your credit card for any emergencies that arise. To pay the credit card bill (in full of course), just sell some of the shares in your bond fund. In most cases, it only takes about one day for mutual fund transactions to settle. Be certain to add in a few days for transferring the money to your bank account as well.
One more point on this is that you should not be worried about incurring capital gains taxes when you sell some shares. As I have said before, short term bond funds tend to be fairly stable, so any capital gain you experience will be minimal.
For The Not So Bold
For those out there who just do not feel comfortable risking some of their emergency fund in the market I offer the following solution. Take three months of your emergency fund and keep it in a savings account. With the rest of the money, you can invest in certificates of deposit. Place equal amounts of money in a one year, two year, three year and five year CD. This will allow you to take advantage of interest rates if they rise. Additionally, any interest you lose by potentially cashing out the certificate early is only three months’ worth. You should still come out ahead, or in the worst case, break even (meaning you get your principal back without any interest.)
I highly suggest you look into increasing the size of your emergency fund to 12 months’ worth of living expenses and also investing some of that money in short term bonds and or TIPS. It’s a great way to lessen the effects of inflation.
How much do you have saved in your emergency fund? Would you consider investing some of that money in short term bonds and/or TIPS?
Interesting article. I currently have $25K sitting in a money market fund (a savings account substitute with my brokerage firm) serving as my emergency fund. But after reading this, I’m going to look into options for investing about $10K of that into something with a little better yield, like a TIPS fund or short-term fund. Maybe even a floating rate short-term fund.