Life

No matter if you call it, an emergency fund or a cash reserve, the idea is that we all need extra money set aside to stay safe from the unexpected. Not having enough cash on hand to pay for an emergency is why many people get into financial trouble. Having a safety net protects your finances and also gives you peace of mind. 

Life happens, and it usually costs money!

But knowing the right amount of emergency cash to keep can be confusing. Today, I'll answer several questions to help you figure out how much your emergency fund should be, the best place to put it, and whether you should invest it. 

Why have an emergency fund?

An emergency fund is a cash account earmarked to pay for the inevitable and unforeseen emergencies in life. Your car won't start. Your computer crashes. Your refrigerator quits. You get sick. You lose your job or business income. Life happens, and it usually costs money!

When you have an unexpected large expense or your income dries up, you need a cash cushion to fall back on to stay healthy and safe. Otherwise, you'll have to make serious sacrifices or rack up debt on a credit card.

I compare an emergency fund to a moat surrounding a fort or castle to protect it from invaders. An emergency fund helps you stay safe from harmful problems that could invade your financial house. 

In general, it's best to keep emergency savings in an FDIC-insured bank account.

Since emergencies happen in a split second, you need cash in an account you can tap immediately. In general, it's best to keep emergency savings in an FDIC-insured bank account. Emergencies can't wait for a CD or bond to mature or for you to sell a valuable asset or a home to raise needed cash.

What if my savings account doesn't pay much or any interest?

I know that keeping a lot of money in a low or no-interest savings account can seem counterintuitive or feel frustrating. A podcast listener named Tena J. says:

I have a 401(k), and $30,000 in savings not making any interest. I know that I need to put this money somewhere to invest for retirement. What's your advice?

Thanks for your question, Tena. I recommend that you think about your emergency savings and your retirement investments as two separate buckets of money with different purposes. 

Even though we tend to use the terms saving and investing interchangeably, they're not the same. The difference has to do with taking a financial risk. You need an emergency savings account that is kept safe and entirely free from risk so it's there when you need it. But the purpose of investing is to put your money at some level of risk in exchange for future growth. Remember that there's always a tradeoff between financial risk and return. Investing money means you could get relatively high returns, but that you could also lose some or all of it.

Even though savings accounts currently pay very little interest, that's the price of keeping money completely safe.

If your emergency money is invested rather than saved, it's subject to volatility, which means the value could plummet when you need it. Having cash in a bank savings or money market deposit account means that it's safe no matter what happens in the markets, but you won't earn much. And that's okay! Even though savings accounts currently pay very little interest, that's the price of keeping money completely safe. Again, remember the purpose of those funds isn't to grow but to be your safety net.

Make sure you always have enough cash on hand to protect yourself from an emergency. I recommend that you maintain a minimum of three to six months' worth of your living expenses in your bank account at all times. 

Tena, I like that you're also thinking about retirement but make it a separate goal. It's better to make regular contributions to your 401(k) and max it out when possible than to empty your savings. Tapping a retirement account for a potential emergency isn't always possible, and if you do take an early withdrawal before age 59.5, you must pay taxes plus a 10% penalty.

I recommend that you maintain a minimum of three to six months' worth of your living expenses in your bank account at all times.

To calculate the right amount of emergency savings, tally up your living expenses. They are just the basics—like housing, groceries, medicine, transportation, and existing loan payments—not necessarily a full replacement of your income. 

For instance, if you could get by on $3,000 per month if you lost all your income, then always keep a minimum of $9,000 ($3,000 x 3 months) in reserve. But having a six-month reserve or more is even better since finding a job could take that long.

When you have extra money or more than a healthy minimum cash reserve, you might consider investing amounts above that threshold. But it's critical to evaluate the cash reserve you need based on various factors, such as the number of breadwinners in your family, your job stability, marketability, ongoing expenses, and financial goals.

RELATED: 3 Emergency Fund Mistakes to Avoid

Should you invest emergency money?

Vivian W. asks another question about investing emergency money. She says:

I'm 28 years old and currently save about $20,000 per year. I live with my retired mother, who is 66 and didn't save enough for her retirement. We both have $113,000 in high-yield savings and a CD but want to invest part of it. However, I'm not sure how much cash we should keep in the bank for emergencies. Also, should I be maxing out my Roth IRA every year?

Thanks for your question, Vivian. As I previously mentioned, my recommendation to keep a range of at least three to six months' worth of your living expenses in savings. You could consider investing the excess. Your cash reserve is like having an insurance policy for you and your mother's safety. 

Vivian, everyone should be investing for their retirement, in addition to maintaining a healthy emergency fund. A good rule of thumb is to invest at least 10% to 15% of your gross income in a workplace retirement account or IRA. The maximum annual IRA contribution for 2020 and 2021 is $6,000, or $7,000 if you're over age 50. Since you can save $20,000 per year, I would definitely max out your Roth IRA every year.

Should you buy a home with emergency money?

Another common question is whether you should use emergency savings as a down payment on a home. Ann C. says:

I'm 21 years old and will graduate from college in May with a full-time job that starts in 2022 in a large city where I've never lived. I have enough savings to make a $20,000 down payment on a home. It seems like spending $1,000 or more per month on rent would be a waste and make it harder to save for a home. Do you think I should own or rent?

Ann, thanks for your question and congratulations on your upcoming graduation, relocation, and new job. That's a lot to celebrate!

If spending $20,000 on a home would leave you with no cash, you can't afford to become a homeowner yet. Buying a home is not an emergency. You always need to maintain a healthy cash reserve no matter whether you own or rent.

Buying a home is not an emergency. You always need to maintain a healthy cash reserve no matter whether you own or rent.

Additionally, becoming a homeowner comes with lots of additional expenses on top of your mortgage payment, such as insurance, property taxes, homeowners association fees, furnishings, repairs, and maintenance. Don't get me wrong—I'm a big proponent of being a homeowner and investing in real estate when you can afford it. 

Ann, since you've never lived in the city where you're going for your new job, I'd recommend renting for several reasons. One is that you need time to get to know a new city and see where you want to be relative to your office. Renting gives you time to understand what the traffic is like, whether public transportation is an option for commuting, where you like to spend time when you're not working, and the state of the real estate market.

I don't recommend buying a home unless you're sure you will live in it for at least three to five years. If you start your new job and don't like it, you might need to sell a home that you just bought to relocate to another part of town or a new city. That may not be a problem, but it's a bit risky. 

I've made several cross-country relocations to big cities and have always rented first to get to know the new landscape and my employer. That gives you plenty of time to figure out the parts of town you like and fit your budget. 

Renting gives you more mobility and freedom when you're in an uncertain situation. Also, in many big cities, it's less expensive to rent than buy a comparable property when considering the total costs of ownership. So, take the time to evaluate your options carefully.

RELATED: 8 Steps to Buying a Home You Can Afford

Should you keep emergency money at home?

You might wonder if keeping some amount of your cash reserve at home is wise. There's nothing wrong with keeping a small percentage of your emergency money in a safe place at home. It could be helpful in a situation such as a natural disaster when there are widespread power outages. 

Typical homeowners or renters insurance doesn't cover cash.

However, be aware that typical homeowners or renters insurance doesn't cover cash. So, if your money gets stolen, lost, or destroyed in a fire or storm, you don't have any recourse.

How to build your emergency fund

If you haven't started an emergency fund, accumulating several months' worth of living expenses can seem daunting. Depending on your income and financial situation, it could take years to achieve. That's okay—just get started by taking small steps every month. 

Your emergency savings should be a moving target that you reevaluate every year.

If the pandemic has taught us anything, it's that we never know what's around the corner. Your emergency savings should be a moving target that you reevaluate every year. 

The first step is to accurately figure your monthly living expenses. As I mentioned, they include housing, utilities, insurance, food, loan payments, transportation, etc. Add up all your current financial needs and obligations for yourself, your family, and third parties that you couldn't or wouldn't want to cut if your income was significantly reduced.

The second step is to estimate how long you could potentially need your emergency money. I recommend saving no less than three months' worth of living expenses. But your unique situation might call for considerably more. Here are some tips to help you determine how much you should set aside:

• Consider your income stability. Do you or a spouse work in an industry with volatile consumer demand or one that's already seen massive declines? If so, this should prompt you to consider saving more than six months of living expenses. 
   
• Factor in any potential large expenses. If you might have additional costs to cover, such as a child's college or a new car, add 10% to your calculated monthly expenses. 
   
• Don't count on selling stuff. When times get tough, it can be challenging to sell possessions quickly to raise cash. So even if you have a valuable collection of jewelry, cars, or artwork, don't consider it your emergency fund. You need still need cash in the bank to fall back on.

If you're not a disciplined saver, try automating your emergency savings. Ask your employer to split your paycheck between your regular checking and your emergency savings account. If you get a paper check or are self-employed, set up an automatic monthly or weekly transfer from your checking into your emergency fund. 

Ask your employer to split your paycheck between your regular checking and your emergency savings account.

An emergency fund is one of the most critical financial "must-haves." It should be large enough to get you through a crisis, easily accessible, and in cash to ensure its safety and liquidity, no matter what's happening in the financial markets.

So, there's no time to spare in getting started. Once you have a safety net in place, you'll have a fantastic sense of security and peace that no matter what happens in your financial life, you're prepared to tackle it.