How Much Emergency Fund Do You Actually Need?

My first attempt at an emergency fund lasted about forty minutes. I opened a spreadsheet, found the advice everybody gives, multiplied my monthly expenses by six, and looked at what came back.

My expenses were $4,200 a month. Six months of that is $25,200. I was saving something like $400 a month at the time, so the spreadsheet informed me I was 63 months away from being a responsible adult.

Five years.

So I did what anybody does with a goal that far out and that abstract. Nothing, for about a year, while the spreadsheet sat in a folder I stopped opening.

The advice was not wrong. The starting number was.

Start with one month

One month of expenses at $4,200, saved at $400 a month, takes ten and a half months. That is not fast either, but it is a thing you can picture finishing, and you can watch it get closer every payday.

More to the point, the first month of cash does almost all of the work. It is the difference between a $400 problem staying a $400 problem and a $400 problem turning into a balance you carry for a year.

The six month number is not useless. It is just the last chapter of the book being handed to people on page one.

What the cash is actually for

The transmission goes on a Tuesday. The shop wants $2,400 before they hand the keys back, and they want it today, because your car is occupying a bay they need.

You do not have $2,400, so it goes on a credit card. At 24 per cent, that balance costs $48 in interest in the first month alone, before you have paid a dollar of it down, because $2,400 times 0.24 divided by 12 is $48.

Nothing about that is a catastrophe. It is a slow leak, and the slow leak is what cash prevents. Here is what my own fund has actually paid for in the years since.

• A car repair I could not defer, because the car was how I got to work and a rental was $61 a day.
• A health plan deductible, which arrived as a bill six weeks after the thing that caused it and had nothing to do with that month's budget.
• Four weeks between one job ending and the next one starting, which happens to people in good markets and not only bad ones.
• A rent increase I had not planned for, plus the first month and deposit on the place I moved to instead.
• A flight home for a funeral, booked three days out, at roughly four times what the same seat cost a month earlier.

Not one of those is an investment decision. They are all the same decision, which is whether the money is there on the day somebody asks for it.

What does not belong on that list: a deposit on a holiday, a sale on something you wanted anyway, and a tax bill you knew was coming in April. Those are planned spending with awkward timing, and they need a pot of their own rather than this one.

How many months you actually need

The six month rule was built for one specific reader: a single income household with a job that would take a while to replace. If that is not you, you are saving for somebody else's risk.

What actually determines the number is how your income arrives and how long it would take to replace.

Pick your row, but build the first month before you think about the rest of it. Every row starts at one.

Where to keep it

In a high yield savings account, which is a plain savings account at a bank that competes on rate instead of on branch locations. It is not an investment product and there is nothing clever about it.

The rate is quoted as APY, annual percentage yield, meaning the rate you actually earn over a year once the compounding is counted. Say the account pays 4 per cent. On $10,000 that is $400 a year. The same $10,000 in a big bank checking account paying 0.01 per cent earns $1.

Four hundred dollars against one dollar, for the same money, doing the same job, available on the same day. Rates move and the 4 per cent above is an example rather than a promise, but the gap between the two kinds of account has been wide for a long time and the arithmetic works the same at any rate.

Check that the bank is federally insured, which for a bank means FDIC and for a credit union means NCUA. There is a per depositor, per bank cap on that insurance, and if your emergency fund is anywhere near it you should look up the current figure rather than take mine.

Where not to keep it

• Your everyday checking account, because money you can see from the app you open twice a day is money you will spend.
• The stock market, because the month you need it is disproportionately likely to be a month the market is down, and selling at a loss to fix a boiler is how a $3,000 problem becomes a $3,800 problem.
• A certificate of deposit, or CD, which locks the money for a fixed term and charges you a penalty in forfeited interest to break it early. Fine for money with a date on it, wrong for money with no date.
• Cash in a drawer, beyond a couple of hundred dollars for the day the card readers are down. It earns nothing and it is not insured against anything.

I keep mine at a bank my debit card has never touched. Transfers out take one to three business days.

That delay is the feature. A genuine emergency waits two days. A sofa does not.

How the money actually gets there

I have never once succeeded at saving whatever was left at the end of the month. There was never anything left, because there is a version of me who spends exactly what is in the account and no more.

Set an automatic transfer for the day after payday instead. On a fortnightly pay schedule, $200 a payday is $5,200 a year, because 26 pay periods times $200 is $5,200, which clears a month of expenses in my example with room over.

Start it smaller than feels impressive. $50 a payday is $1,300 a year, and the $50 version will still be running in November, which the ambitious $400 version will not.

What if I am carrying debt at the same time

This is the question almost everybody actually has, and the order is one month of cash first, then the debt, then the rest of the fund.

The first month is what stops the next $2,400 repair landing straight back on the card you are trying to clear. Without it you pay the card down and refill it every few months, which feels like effort and is really just pacing.

Past that first month, a card at 24 per cent beats a savings account at 4 per cent by twenty percentage points. On a $5,000 balance that gap is $1,000 a year, because 5,000 times 0.20 is 1,000. Clear the card, then come back and finish the fund.

When to stop adding

When you hit the number in your row, stop. An emergency fund is insurance, not a strategy, and cash past the point of covering the emergency is cash doing a job it is bad at.

Redirect the contribution the same week you hit the target, before the habit dissolves. If you are carrying a balance at 20 per cent or more, that is where it goes, because no savings account will ever pay you what that card is charging.

Open a savings account at a bank you do not already use, and move one month of expenses into it. Then go and look at what your highest balance card is actually charging you, because that is the next number that decides things.