When you've gotten yourself into a solid financial position after struggling to get out of debt, one thing a lot of people forget to do is to shore up their defenses, and save up a large emergency or contingency fund. You never know when you're going to have a life altering emergency or random health event, and without having a large savings buffer you could end up in big trouble.
Today I want to explore the reasons for having a large emergency fund saved up and available.
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Why You Should Save 3 To 12 Months Of Expenses In Savings
I've set the 3-12 months of expenses as a goal because a variety of financial gurus from Dave Ramsey to Suze Orman have suggested building an emergency fund anywhere from 3 to 12 months. Dave suggests 3-6 months, while I've seen Suze suggest a fund more in line with 8 months of expenses. Personally at our house we prefer even larger contingency funds – in the line of 10-12 months.
The reason for building up this reserve? With this reserve you're building your safety net against major life events so that you never have to go into debt again.
When you have multiple months of income saved there aren't very many things that can happen that you can't pay cash for outright.
Lose your job? You'll be able to cover the mortgage long enough for you to find a new job. Have to get unplanned surgery? Your emergency fund will cover your portion of the bill (make sure you have good health insurance!).
Emergency funds help you to get rid of the risk of unplanned for events, and prepare for the future.
Why Build An Emergency Fund?
Often times people think it's just a waste to build an emergency fund that is so large. It just seems to be overkill. Why not use the money for something else?
Personally I can think of a lot of reasons why it's a great idea.
- Things Happen: Unexpected expenses WILL come up, and it's better to have planned for it than to stick your head in the sand. If you don't plan for those things they'll end up happening at the worst possible times. Your heat will go out in the middle of winter, or you'll end up in the emergency room for an unknown allergy. I’ve realized more and more over time that emergency funds are necessary because life happens and small unexpected expenses WILL come up. When you have the money saved these things are an annoyance, but not the end of the world.
- Manage Stress: When you have an emergency fund saved, life is a lot less stressful. You don't have to worry about what you'll do if a negative event falls in your lap. You just pay to get it fixed.
- Risk Is Reduced: When you have an emergency fund (along with other things like health insurance, disability insurance and life insurance), you have a lot less risk of having a bad situation turn into a catastrophe. A medical problem won't turn into bankruptcy, and a job loss won't turn into a foreclosure. In other words you’re making sound decisions to plan for problems, before they happen. You manage the risk that comes along with those major negative events, and stop them from turning into life changers.
How Much Is Enough?
The decision of how much money to save in your emergency fund is one your family will need to talk about. The amount may vary depending upon your living situation, number of children, job stability and other factors. The very minimum I think would be at least 3-4 months of expenses. For those with less stable careers or who fear layoffs in the near future – larger 10-12 month emergency funds aren't a bad idea.
If your family has a minimum of $3000 in expenses every month after cutting out all the un-necessary bills, your 3-12 months of expenses would come out to anywhere from $9000-$36,000.
How many months you save will be dependent on your situation. At our house since we like the peace of mind that comes with the emergency fund, we have saved 12 months of expenses, if not a little bit more.
- If you're single and have a relatively low level of needed income every month, you may be able to get by with only 3 months of expenses.
- If you're the only bread-winner bringing home an income for a family of 5, then you may want to err on the side of caution and keep a buffer of 10-12 months of expenses (or more).
- If you're expecting a major life event in the near future (layoffs, surgery), you may want to start stockpiling cash in advance, and save as much as you can – as fast as you can.
Where Should I Put My Emergency Savings?
Where you save your emergency fund is really up to you. The only thing I would say about this is to make sure that you put the money somewhere that you can get at it right away if you need to.
My personal preference for a good place to save the money is a good high-yield savings account. We've currently got ours stored with two different banks, ING Direct and Ally Bank – a majority with Ally as we've found their bank transfers to be a bit quicker. To find a listing of good banks that you could use, check out our list of current bank rates. It doesn't matter that much what bank you choose, as long as the money is liquid and available quickly.
Don't put your emergency savings in things like real estate, long term investments or other things that could be tied up for a while without you being able to get at the money. Keep it liquid!
How much do you have saved in your large emergency fund? Do you have closer to 3 or 12 months of savings set aside?