How to Build an Emergency Fund
Ok, so you made the decision to build an emergency fund, now what? How much of an emergency fund do you really need? Before I answer that question, let’s drill down into why emergency funds are a critical aspect of a strong financial foundation.
Why Do You Need an Emergency Fund?
An emergency fund helps prepare you and your family for the unexpected. While losing a job is one possible, unexpected event, there are thousands of more things that could happen that would bring hardship to your family if you were not financially prepared with an emergency fund. There could be unexpected medical expenses, someone in your family going through a hardship that needs financial assistance, a car biting the dust, you dying, etc.
Now that you’re terrified because you don’t have an emergency fund, let’s do something about it.
How Do You Build an Emergency Fund?
You must have some sort of budget in place if you want to contribute money to your emergency fund on a regular basis. If you haven’t already implemented a budget, then I recommend the 50-20-30 budget. This is where you spend around 50% of your take-home pay on needs, 20% towards financial goals, and 30% on wants.
In your case, your current financial goal is to build an emergency fund, so 20% of your take-home pay should go into your emergency fund every month until you hit your goal. If you want to build your emergency fund as fast as possible, then trim down on your wants and spend around 50% of your take-home pay on needs, 30% towards financial goals, and 20% on wants.
Where Will You Store Your Emergency Fund?
There are a ton of different options out there, but to stay true to my word of never overwhelming you with options, I’ll just tell you what I use. I store my emergency fund in cash in a high-yield savings account (HYSA) with Ally for a few reasons:
- The interest rate provided (4.25% as of November 2023) absolutely smashes the savings rate available at my daily bank (.15%)
- It’s separate from my daily bank, so it’s slightly inconvenient (i.e., takes 2-3 days) to transfer money away from the HYSA and into my checking account. This will help discourage using my emergency fund for non-emergencies
- The cash is accessible (within 2-3 days) and will be stored as cash so it is available if I actually need it
- It allows me to organize my money into buckets, so I can further subdivide the money in the savings account into specific goals
How Big of an Emergency Fund Do You Really Need?
Chances are you’ve read about emergency funds on other websites, or you’ve heard them talked about in personal finance podcasts. If so, then you should be very familiar with the rule of thumb that states your emergency fund should consist of 3-6 months of living expenses. However, if you meet certain criteria, then you should really think about extending that emergency fund to 12 months.
Ok, so how much should you save? 3 months? 6 months? 12 months?
Here comes the annoying, blanket answer for anything personal finance – It depends.
Of course. Why would you think this would be a straight-forward answer?
3-6-9 Rule
Enter the 3-6-9 rule. While commonly confused for Lil Jon and the East Side Boyz lyrics to their 2003 smash hit, Get Low, the 3-6-9 rule is actually a loose guideline for emergency savings. The 3-6-9 rule says, save:
3 Months of living expenses if you:
- Have reliable, regular income
- Rent your housing
- Do not have any dependents
6 Months of living expenses if you:
- Have reliable, regular income
- Have multiple income streams
- Pay a mortgage
- Have dependents
9-12 Months of living expenses if you:
- Have unreliable, irregular income
- Are a single income household
- Pay a mortgage
- Have dependents
You might have a few questions, like “What is reliable, regular income?” Great news for you. All those answers are below.
Emergency Fund Variables
The below graphic, which I spent far too much time on for how it turned out, provides a high-level view of the different aspects of your life that drive how big of an emergency fund you need.
All of these variables look into how exposed you would be in the event of a financial hardship. It is your responsibility to see where you fall in each of these categories and then back into your emergency fund goals based on your risk tolerance. Another way to look at it is below.
Income Variables
Your income is the first part of the equation. However, it isn’t the amount of money you make that has an impact on your emergency fund, but the diversity, regularity, reliability, and replaceability of your income.
Diversification
How many different income streams are coming into your household? Does one income source account for the overwhelming majority of your household income (e.g., Two income streams but one of those streams accounts for 95% of your total income)? The more dependent you are on a single source of income, the more impacted you would be if that income stopped.
Do both you and your partner work, but are in the same industry? Or even the same company? If so, then you are not as diversified as you could be. A downturn in your industry could cause both of you to lose your jobs at the same time. If you work for the same company, then a single round of layoffs could leave you both jobless.
Think through your income diversification. The less diversified your income (i.e., one income stream or multiple income streams from the same, or similar sources), the larger your emergency fund should be.
Reliability
How confident are you that your income is going to continue to hit your bank account? Do you receive a paycheck regardless of your performance? Are you dependent on closing deals to receive the majority of your income? Are you dependent on someone else assigning you hours to make the income you need to cover your expenses?
The higher you are on the reliability scale, the less of a risk “income reliability” is to your financial situation. All other things being equal – this means that someone that is commission-based would likely need a larger emergency fund than someone that is salary-based.
Regularity
Income regularity is somewhat related to income reliability, but it also deals with the structure in which you are paid (fixed vs variable), and how frequently you are paid. Do you receive a paycheck for the same amount every 2 weeks? Or do you make a big sale once every 3-4 months and you receive a big payday then?
If you receive fixed income on a predetermined schedule (e.g. The 1st and 15th of every month), then you have lower “income regularity” risk than someone that receives a varying amount of income on an irregular basis (e.g., every 3-4 months). The higher your “income regularity” risk (i.e., the less structure around the amount and frequency in which you are paid), the higher your emergency fund should be.
Replaceability
Are you a clown that specializes in making ballon animals of albino baby rhinoceroses that have an extra horn? If so, then your specialty is extremely niche and I imagine you would have a hard time finding another job if your zoo that has an albino baby rhinoceros with an extra horn fired you.
People say “the riches are in the niches” because specialists can charge a premium for their services. However, there is also riskiness in the niches since it will likely be harder to find work in the even of job loss.
The higher your “income replaceability” risk (i.e., the longer it takes you to find another comparable paying job), the higher your emergency fund should be. In my opinion, this is one of the major factors that would drive me to save beyond the 3-6 month emergency fund and start flirting with 9 or 12 months.
Dependents
Are people dependent on you? Are you a bachelor, or do you have a family that you support? The more people that are relying on your ability to bring in money, the more impactful a financial hardship might be.
A bachelor might be okay in downgrading their living space, or taking on new roommates to help make ends meet. However, a person that is supporting their spouse, children, and in-laws may not have the same flexibility.
According to the 3-6-9 rule, a person with dependents should have an emergency fund of at least 6 months of living expenses. This might be aggressive, so assess this recommendation against your risk tolerance and your other income variables to see if it makes sense for you.
Risk Tolerance
An often overlooked aspect of building an emergency fund is an individual’s risk tolerance. If you want to have 12 months of living expenses sitting in an HYSA emergency fund and it will help you sleep better at night, then do it. An emergency fund is there to help you sleep at night and to keep life’s unknowns from financially ruining you or setting you back.
If you are completely okay with risk and you have no problem sleeping at night, then you should still keep at least 3 months of living expenses set aside.
Bonus Personal Factor – Rent vs Own
Consider whether you rent or own our home as another variable when determining how big your emergency fund should be. If you own your house, then you should either increase your emergency fund to include some planned or unexpected household expenses (e.g., replacing your roof every 25-30 years, replacing your furnace every 15-20 years), or have a separate account or bucket for your major house expenses.
My recommendation would be to keep your true emergency fund separate from your planned housing expense fund. That way you aren’t depleting your emergency savings if your hot water heater breaks and you need to replace it. Keep your “planned expenses” funds separate from your “unexpected expenses” funds.
This is where the bucket feature in Ally becomes handy. It will allow you to have a single account that would have a bucket dedicated to emergencies, and another bucket dedicated to major house expenses.
If you own your home and live in an HOA, then you should also have some money set aside for any unforeseen assessments that the HOA may require its members to contribute towards. You don’t want to be hit with an unexpected bill for redoing your neighborhood pool and not have some extra HOA cover you ass money set aside.
If you rent, then you don’t need to worry about your furnace breaking and having that take away all of your emergency savings. You would just need to call your landlord and it’s their financial burden to carry. If one of your financial goals is the buy a house at some point in the future, then you could use the Ally bucket feature to start saving for a down payment.
Bonus Macro Factor – The Current State of the Economy
If I haven’t lost you by now, here is where I turn on the afterburners by talking about how the economy might impact how much you want to save.
Relax, I’m not going to tell you that you need to do in depth analysis on Treasury yield spreads and how they correlate with whether or not Punxsutawney Phil saw his shadow. Frankly, financial “experts” can’t even predict what the market is going to do, so it’s a worthless exercise for you to do.
Just pay attention to the general sentiment towards the economy. What is the news saying? Are people talking about how the market is hitting all time highs? Or are they talking about a looming recession?
If you are hearing talks of a looming recession, then maybe start setting some additional emergency funds aside in case the economy tanks and you end up being directly impacted.
If you work in an industry that fluctuates with the economy (e.g., retail, restaurants, travel/tourism), increase your emergency fund. Your ability to generate income carries a little more risk than a plumber that will always have work, regardless of the state of the economy.
Conclusion
We have arrived at the the end. Are you more confused now than you were at the beginning? If that’s the case, then let’s try to clear it up a bit.
Key Takeaways
- You absolutely need an emergency fund, regardless of how much you make or how secure your job feels
- Your emergency fund should consist of at least 3 months of living expenses, with the typical sweet spot being 3-6 months
- The riskier your income, the larger your emergency fund should be (i.e., 6 months, or even 12 months in certain circumstances). Your income can be considered risky if :
- You only have one source of income
- Your pay frequency and/or amount are sporadic
- Your job is extremely specialized and it would take time to find a new job
- You work in an industry that is heavily impacted by the state of the economy
- The more people that are depending on your income, the larger your emergency fund should be
- If a 3 month emergency fund is going to cause you to lose sleep at night because you are risk intolerant, then build a larger nest egg
- If you own your home, then you will be on the hook for paying for major issues. Start setting money aside in a separate account/bucket, so you don’t have to drain your emergency fund if your 26 year old furnace breaks
- Build a larger emergency fund if you work in an industry that is often impacted by economic downturns. Do this even if the economy is booming. Make hay while the sun is shining. It will be a lot harder to aggressively save if your hours get reduced
