Everyone needs an emergency fund to use should they experience the unexpected. Job loss, falling ill, or having other major financial catastrophes can wreak havoc on your finances. When you have an emergency fund set aside, though, you can focus on overcoming the emergency and not stress about how you’ll pay your bills.
But is there such a thing as having too much money saved for an emergency?
There could be. Saving too much for the wrong reason can cause you to feel it in other areas. Here’s what you should know.
What is an Emergency Fund?
First, let’s define an emergency fund. It’s an account to be used for EMERGENCIES only. Emergencies are life-altering occurrences that make it impossible to either make money or the emergency costs so much money that it interrupts your regular budget.
This account should be kept separate from all other accounts and be hard to access so you don’t spend it.
How Much Should You Have in Your Emergency Fund?
There are two common rules of thumb people use when determining how much to save in their emergency fund.
The first and the easiest is to save 3 to 6 months of your monthly expenses. Let’s say you spend $5,000 a month on your basic bills and money to cover your basic needs, such as food and clothing. Then you should have $15,000 – $30,000 saved to cover those expenses should you suddenly be unable to cover them.
Some people, however, believe they should have 3 to 6 months of their monthly salary saved. This is another great thought, but it can be a bit harder to accomplish. For example, if you make $8,000 a month, that’s $24,000 – $48,000 saved, which could be excessive.
Only you know which number sits right with you, giving you peace of mind should something happen.
What Expenses Should You Include in Your Emergency Fund?
As you figure out if you should save 3 – 6 months of expenses or your salary, it’s important to understand which expenses you should include in your emergency fund.
Your emergency fund should include enough to cover your basic living expenses. This doesn’t include money for entertainment, eating out, or unnecessary shopping. Instead, you should have just enough to make sure you and your family can cover the necessities while you deal with the emergency.
Here are some common examples of the expenses.
Whether you have a mortgage or rent payment, your housing payment should be a priority. Having 3 – 6 months of your housing payment saved ensures you and your family don’t have to worry about your living situation during an emergency.
If you own your house, you should have enough money to cover all necessary utilities for 3 – 6 months. This includes gas, electricity, water, and garbage. If you rent, you might only have a few of those utilities to cover.
You’ll need basic transportation even during an emergency. Total up what it costs to pay for your car (if you have a car payment), gas, tolls, parking, and typical maintenance to determine how much you should save to cover 3 – 6 months.
Your emergency fund should include enough money for necessary food for 3 – 6 months. This includes only food you buy from the grocery store to meet your family’s needs for a month – not money to eat out.
Have enough money saved to clothe each person in your family with the necessities, especially as the seasons change. This doesn’t mean enough money for an entirely new wardrobe, but enough to ensure each person has the necessities.
Always include the cost of your medical care. This might include insurance premiums, co-pays, and enough money to cover your deductible. If you regularly take prescriptions, include money for those too.
When Should You Use an Emergency Fund?
Here’s the tricky question – when should you use an emergency fund? We all define emergencies differently, but there are some pretty straightforward guidelines for emergency funds.
You should use an emergency fund only when you are unable to work, such as you fall ill, you are let go, or you experience such a dire emergency that it makes it impossible to meet your budget, such as a total house disaster or a major medical crisis.
You shouldn’t use an emergency fund because you decided to quit your job, or you didn’t feel like working for a few weeks. You also shouldn’t use it to make up for overspending on your credit card or not paying attention to your budget.
4 Reasons You Might Be Saving Too Much in Your Emergency Fund
Now that you know how much you should be saving in your emergency fund, you should know that there are reasons you might be saving too much. Many people assume more is better and with money that’s usually the case, but there is an opportunity cost of putting all your money in your emergency fund and not somewhere else.
Emergency funds are typically kept in savings accounts or online high-yield savings accounts, earning 1% at best. While that’s fine for the funds you need to keep liquid in case of an emergency, it can be overkill if you save too much in there.
You Have Credit Card or Other High-Interest Debt
If you have high-interest consumer debt, such as credit cards, you lose money each month that you carry a balance. You can’t outpace the interest you’ll pay on a credit card (unless you have a 0% APR credit card) with any type of savings.
Once you have 3 – 6 months of expenses saved, use your extra money to pay down your credit card debt. In the worst-case scenario if you needed more money in an emergency, you’d have your credit lines available should you run out of emergency funds. In the meantime, though, you wouldn’t be overpaying in interest charges.
You’re Sacrificing Other Savings Goals
There are other things in life to save for besides emergencies. Sure, you should always be prepared for the worst, but you should plan for the best too.
What about saving for a down payment on a house or car? Maybe you’ve dreamt of taking your family on an amazing vacation or you want to save for your child’s college education. Saving money for other goals is important. Otherwise, you’ll find yourself sacrificing many of your life’s goals just to keep funding your emergency fund.
You Aren’t Contributing to Your Retirement
If you work for someone and they have a 401(k) with an employer match, you’re giving money away if you don’t contribute to it.
For example, if you make $50,000 a year and your employer matches up to 3% of your salary in 401(k) contributions annually, this means they’ll contribute $1,500 per year if you do. It’s a match, so you must contribute first. If you don’t, that’s $1,500 per year plus compounded earnings that you’re losing. If you stay at your job for 10 years (with the same income), that’s $15,000 you’re losing.
You’re Sacrificing Other Investment Opportunities
Saving money is great, but investing is even better. Aside from investing in your retirement, you might want to invest money for other goals or just to compound your earnings. If you put all your money in your emergency fund, you won’t have money to invest in stocks, bonds, real estate, or other commodities.
What’s a Sinking Fund and Is It the Same as an Emergency Fund?
An emergency fund, we established, helps during a major emergency, but a sinking fund is another fund you could have that would help in certain situations.
A sinking fund is a fund you contribute to monthly to pay for annual or infrequent expenses. For example, let’s say your house usually costs around $3,000 a year to maintain. If you keep adding to your sinking fund to make sure you have the $3,000 to cover those expenses, you don’t have to use up your budget or risk using your emergency funds because you let the house go so long that it has a major catastrophe.
Knowing just how much money to have in your emergency fund is important. Putting too much in your account is an opportunity cost to other savings vehicles, but not saving enough could be detrimental during a serious emergency.
This article is provided by EveryIncome.