3 Factors That Determine the Size of an Emergency Fund

Today’s article is a follow-up to another post, “5 Key Reasons to Establish an Emergency Fund Now,” which explained why you should have an emergency fund.  As promised, I will now describe the factors one should consider when determining the appropriate size of an emergency fund.  One overarching consideration is that an emergency fund should be just large enough to accomplish its purpose and no larger.  By its very nature, an emergency fund should be kept in a bank savings account.  The bank should be a prominent institution with FDIC insurance.  The unfortunate byproduct of safety is low-interest rates on deposits.  An emergency fund that is too large means that money is left on the table, not working for its owner.

So how much money should be in an emergency fund?  I’ll start with the rule of thumb: three to six months of emergency expenses.  Once past the rule of thumb, I’ll explain how to factor in insurance deductibles and copays and, finally, how to view individual and total risks that increase or decrease the size of the emergency fund.

Start with 3-6 Months of Expenses 

Why three to six months?  The idea, at its most basic level, is that most people should be able to find new employment in three to six months if they lost their job.  A realistic assessment during most normal economic times, it means that lifestyle doesn’t change drastically during the period of unemployment.  Three to six months is a wide range, though.  Individuals in a high turnover industry should be more conservative with a more significant emergency fund.  The same goes for individuals who live in areas with struggling economies.  On the flipside, people with skills in high demand or careers with relative security could get by with a smaller emergency fund.  For my military clients, I tend to start my calculations with three months of reserves.

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5 Key Reasons to Establish an Emergency Fund Now

The emergency fund is nothing new in the financial world.  Many of us bloggers pontificate on the need to maintain a proper emergency fund and rightly so.  But why should we hold a bunch of cash that earns almost no interest?  And how much should we hold?  The answers to these questions are more complicated than we are usually led to believe yet the emergency fund is the cornerstone of a successful financial or investment plan.  First, I’ll start with five reasons to have an emergency fund and then, in the next post, build into the factors that help determine the proper size of an emergency fund.

1. Keeps you out of debt.

Once the emergency fund is established alongside a realistic budget, the fund helps limit the need to pull out that credit card or take out a personal loan for unplanned expenses.  While not all debt is bad, it’s essential that any loans come as part of a deliberate plan, not a surprise expense.  The result is that the emergency fund allows a person to absorb a car breakdown or pay an insurance deductible after a storm damages the house without suffering debt repayment over the following months.  Most importantly, it keeps people out of significant debt if they temporarily lose their paycheck.

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PCS Time: Rent or Buy?

Warning Order

As the summer months rapidly approach, so does the primary moving season for members of our military.  With any move comes the inevitable debate over renting or buying a home.  While this debate involves both emotional and financial dynamics, I’ll discuss the financial aspects.  Ultimately, the desire to own your home can be powerful and might sway the final decision, but the financial aspects of the decision aren’t so clear.  In fact, due to military moves that happen every three years on average, it usually makes financial sense to rent.  Analysis indicates that the transaction costs associated with buying and selling a property eat away at most potential equity gains in the short timespan absent significant increases in home value.  As a result, owners take on significantly more financial risk in return for paltry expected returns.

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The Most Powerful Variable in Investing: Time

Warning Order

When discussing saving and investing, people, including financial advisors like me, often explain the power of time in building wealth.  We then go on to explain annual returns, the rule of 72, investment allocation, blah blah blah.  Investors can get lost in the details.  Instead, let’s look at the variable of time differently: how many times can we double our money?Read More »

Pay Off Your Mortgage

Warning Order

One of the hallmarks of the American dream is homeownership.  We have an entire regulatory and tax structure along with government-sponsored entities to support home ownership through the standardized 30-year fixed rate mortgage.  In this environment, it’s possible to purchase a home with a 20% down payment (sometimes less) while committing to 30 years of payments at relatively low-interest rates.  But how does a mortgage fit into a financial plan?  In short, makes decisions about mortgage terms and purchase price should with an eye toward paying off the mortgage by the beginning of retirement.Read More »