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Emergency funds are a great way to protect your finances from an unexpected expense. With that in mind, does that mean that bigger is better? Not necessarily, holding too much in your emergency fund can actually be harming you.
Emergency funds should be 3-6 months of expenses. Holding too much in your emergency fund presents lost opportunity cost, as the returns on your emergency fund will be minimal. The amount you hold in your emergency fund will depend on your lifestyle, risk factors, and risk tolerance.
Emergency funds are great, but it’s important to do a review of your life to find out the correct amount you should hold.
How Much Do I Need In My Emergency Fund?
In general, you should hold 3-6 months of expenses in your emergency fund. A month worth of expenses typically only includes living expenses (e.g. housing, food, insurance, debt repayment, etc.) that you can’t go without. Non-living expenses should not be included (e.g. eating out, vacations, etc.), as it’s assumed in an emergency you would have to drop these from your budget.
Determining how much you need in your emergency fund is a personal exercise. There are three things to consider: your lifestyle, your risk factors, and your risk tolerance.
Lifestyle
As mentioned above, the recommended amount of money for your emergency fund is 3-6 months of expenses. Now these expenses could differ greatly between people. What you deem an expense vs. a frivoulous purchase will also depend.
To determine your monthly expenses, the first step is to track your spending, to get an understanding of how much you spend per month. From there, you can decide what you’re willing to discard in case of emergency. For example, you may decide that getting dinner with friends is really important to you, so even if you lost your job you’d want to continue. Take all the items that remain after you’ve discarded the items you can drop, and total them up. That represents one month of expenses.
From there you can assess your risk factors/tolerance to determine how many months of expenses to hold.
Risk Factors
Risk factors will impact how much you should hold in your emergency fund.
Some risk factors include having dependants, owning assets that may need repairs, or being in a job that has low security. You should also consider the worst case scenario – what happens if you run out of money.
If you have children or a spouse that depend on your income, the consequences of losing your job are much higher. As such, it’s wise to have a bigger safety net (more months of expenses).
Similarly, if you own a home and/or car(s), they could have emergency repairs. You can assess based on the age and condition how high the risk of this is occuring, but this should also be considered in your decision on how much to hold.
As well, if you work in a volatile industry, a lay-off can be more likely. This means it’s higher probability that you need to use your emergency fund. As such, holding more may be wise.
Finally, you should consider what happens if you run out of money. If you’ve got family or friends to lean on, this may not be too bad. But if you are a recent immigrant for example, and running out of money would be catastrophic, this may spur you to hold a bigger emergency fund.
If you go through that list and determine you’re low risk, you could hold 3-4 months of expenses. If you’re high risk, maybe you hold 5-6 months.
Risk Tolerance
Finally, you should consider your individual risk tolerance.
If you are risk averse, holding more may help you sleep at night. Or if you are more comfortable with risk, you may have no problem holding a smaller emergency fund. It’s important that you consider your money psychology in your decision as well.
As shown, there are a lot of factors to consider when deciding on how big your emergency fund is. It’s important you make the decision based on your individual circumstances.
What’s The Danger of Having Too Much in Your Emergency Fund?
Holding too much money in your emergency fund presents a potential opportunity cost. Because you want your emergency fund to be safe, you will typically get a small return if any. With inflation, your money may even be losing value. If you hold too much in cash, you’re missing out on potential investment returns.
Emergency funds should be held in a high-yield savings account. This provides a balance of liquity and safety, while giving some return. But even the best high-yield savings account won’t match the returns from investing in the stock market. If you hold too much in your emergency fund, you’re sacrificing the potential gains you could have made by investing the money.
For example, let’s imagine you assessed your situation and found you should hold $10,000 in your emergency fund. You decide instead to hold $20,000, storing your emergency fund in a high-yield savings account with 2% returns. Now that additional $10,000 would grow $200 in the first year. This may not seem too bad, until you consider the market has historically returned ~10% per year. If this money was invested, it could return $1,000, and compounding would mean it grows even more the longer it’s invested. By holding this money in a emergency fund, you’re losing out on $800 in the first year alone.
Now you might be thinking, if that’s the case why don’t I invest my emergency fund? This is a very bad idea, as it means the value can drop when you need it, defeating the purpose of the emergency fund. Emergency funds aren’t meant to grow in value, but rather serve as a protection for your financial health. As such, you should hold as much as you need in your emergency fund, but no more.
Is $100,000 too Much For Your Emergency Fund?
Using the 3-6 month rule, holding $100,000 in your emergency fund assumes your expenses are between $16,667 and $33,333 per month. If this is true, then holding $100,000 may be the right amount for you. But if your expenses are less than this (which I assume most people are), you should re-assess the amount to ensure you’re not losing out on potential investing gains.
Is a 12 Month/1 Year Emergency Fund Too Much?
In general, holding a 12 month emergency fund is too much. It’s recommended that you hold 3-6 months of expenses. That said, if you are risk averse, and holding 12 months of expenses gives you peace of mind, it may be the right decision for you. It’s just important that you recognize the potential consequences (see above).
It all depends on your individual money psychology.