Rewind back to when Mrs. FI and I were just married a couple years, we definitely were not what you would call wealthy by any standard. We were newly married, unemployed, and lived with my parents the first year of marriage. Mrs. FI took on odd jobs to earn a little income during this time.
After I finally found a job, it was decent for a new college grad. It paid $20/hour, which was more money than I’d ever seen. We moved into an apartment on the east side of the city but drove cars we “borrowed” from my parents. Eventually, I changed jobs after about a year, jumped to two other jobs and stayed a year at each, then tried my hand at entrepreneurship. I racked up student loan debt from my undergraduate degree, business debt, and had a mortgage.
Through it all, my awesome wife worked to support us. Oh, did I mention that I went back to school to get my MBA using more student loan debt. In short, we were scraping by, and we were one emergency away from some real financial stress. We did not save an emergency during this time, even though back then I was watching Suzy Orman and had an interest in personal finance. I knew what we needed to do, but just didn’t do it.
After a few years of trying to own my own business, did I finally admit it was time to let it go and get back to work. The debt I racked up was too much and I didn’t see my business getting much bigger than where I got it to. I slowly closed up shop while going back to work with my first employer. We sold the house we bought just 4 years earlier (it took about a year to sell as we timed our sale perfectly with the 2008 crash…) and moved back in with my parents.
Although we were blessed and were able to avoid any serious emergencies, we were gambling with our lives. This is not something I would recommend to anyone no matter the situation. We were essentially one major incident away from being in a serious financial crisis. We feel extremely blessed and are grateful every day that we were able to make it through that time without a serious incident.
How much do I save for an emergency fund?
The famous talking heads, such as Dave Ramsey and Suze Orman, talk about establishing an emergency fund as a pillar of their personal finance advice. Dave Ramsey talks about this in his Baby Steps to save $1,000 then later after you pay off your debts through the debt snowball to save three to six months of your income as an emergency fund. Suzy Orman says to save eight to 12 months as an emergency fund.
I have also heard other personal finance experts and bloggers, especially those in the FIRE (Financial Independence Retire Early) community, save at least a year and some up to three years of income as an emergency fund. The reasoning? People in FIRE are looking to retire young(er) and so they need more of a cash buffer in case of an emergency.
Take for example the coronavirus pandemic of 2020. Millions lost their jobs or could not go to work. If you were not one of the lucky ones who could work from home or did not work in a business deemed “essential”, then you likely did not work and had to rely on savings or apply for unemployment. Even the unemployment benefits were not guaranteed if you applied for it.
When we calculated our emergency fund, we focused on essential expenses. Your expenses can be categorized into two groups: essential and non-essential. This can also be called your needs versus wants.
When it comes to essential/needs-based expenses, as its name implies, are expenses that have to happen no matter what to maintain your livelihood. Examples of essential expenses include housing, food, and transportation. These expenses will allow you to stay alive by feeding you, keeping you safe, or bring income.
Non-essential/want-based expenses are those expenses that aren’t needed to maintain your livelihood. Some examples of these expenses include vacations, entertainment, allowance, daily coffee/tea/kombucha, subscriptions, etc. These expenses, while nice to have, are not essential to maintain your life.
It’s important to keep in mind that you are looking at absolutely essential expenses if things got bad, where can you cut and still stay alive and have a safe place to live.
When looking at the essential versus the non-essential expenses, we categorized then cut out all non-essential expenses, then used that as our monthly essential expenses to come up with our emergency fund amount.
The monthly essential spending expenses will not allow you to live luxuriously, so it is going to look very lean. That is the purpose. You have to ask yourself, “what is the bare minimum you need to live?”
Once you determine this number, you can take a multiple of this based upon how much you want to save. For us, we maintained at least 6 months of emergency savings based upon our monthly essential expenses.
No matter if it is 3 months or 36 months, the important point is you save an emergency fund for those just-in-case moments in life. Those moments will happen and you want to be prepared.
If you don’t think you can save that much for an emergency fund because you might be living paycheck to paycheck. This should be a sign you either need to increase your income or decrease expenses.
You can start with a goal of setting aside a certain amount per day or month for savings. For example, if you save $10/day into a savings account or in your drawer, that $10 will turn into $300 in a month and $3,650 in a year. If you can’t do $10, then shoot for $1. It doesn’t matter. What matters is you get started saving. We can’t predict emergencies in our lives, and we want to be ready for it WHEN it happens.
In my opinion, if your job is stable and salary is consistent, then saving closer to three to four months as an emergency fund should be fine. If your salary is not consistent or your job is not stable, then I would definitely lean toward saving six months or even more. If the coronavirus pandemic taught us anything, it is that our jobs are not as stable as we think and emergencies can run longer than three to six months.
Where do I save my emergency fund?
When you save for your emergency fund, where exactly do you put the money? The amount of money you put away is not a small amount and if you are like me, you are trying to think of ways to maximize the returns.
When I first saved our emergency fund, I had it in a savings account in a local bank. However, I hated the fact that money sitting in a savings account was getting such low returns. There’s got to be a way for us to maximize the return on our emergency fund. I decided to do what we did when we were working on paying off my student loans and when we were paying our property taxes.
Back when Betterment was just a startup and had few members, I joined the platform because of the ability to rebalance our portfolio every day. We could go more aggressive or conservative depending on what we wanted to save for. We wanted to make some money off of the money we would be paying in student loans and property tax, so I invested that money with Betterment and set it at a pretty conservative allocation of about 85% stocks and 15% bonds until we needed to pay the bill.
We did not get rich off the money as capital preservation was the primary objective and earned a little bit of money off the money that eventually would go to paying my student loans and property taxes. Looking back, we probably did not make that much money if any at all since we are taxed when we withdrew from the Betterment account since it is a taxable investment account.
When it came to the emergency fund, we had about 6 months worth saved so we wanted to maximize its earnings potential since it is something that is just going to sit there and (hopefully!) will not be used or used very infrequently. Because we used an online bank, Ally Bank, as my primary bank and had a credit union my parents opened when I was a kid and used that throughout my life until we opened my Ally account.
We used the credit union as a backup bank and also as a way to deposit cash since it is near impossible to do so with Ally as they have no branches. We deposited cash into our credit union account then transferred it into Ally since it earned “better” interest on our money. Because of this, we left about 25% in Ally and $1,000 in our credit union account as Betterment took about three business days to transfer money to our accounts.
If we had an emergency, then we had liquid cash we could take from Ally or if we needed cash, we had $1,000 we could withdraw from any credit union. The remaining money, we deposited into our Betterment account and set the allocation to 85/15 stock/bond mix and let it ride. With this allocation, we could expect small gains per year which was much higher than the 1% we were getting if we left it in a high-yield savings account.
Eventually, we deposited most of our savings into the Betterment account including our personal fun money, vacation money, and other savings. At the time, the stock market was doing well and we could press our luck a little more and increase the allocation of stocks higher. We increased the allocation to 50/50 stock/bond allocation. We did see an increase in returns, because now we are seeing the gains from the stocks and thought we were geniuses for doing this. We hit a couple bumps like the short 2018 downturn that lasted all but a few weeks and the stocks and our returns went higher.
Then came coronavirus pandemic…
Stocks fell 30% in a matter of weeks and panic ensued. Businesses closed and people lost their jobs. Looking back now, if we sold everything on February 19, then sat back until March 23 before coming back into the market we’d be sitting pretty.
Because we invested 50% of our emergency fund and other savings in stocks, we were also negatively impacted. Our 50% bond allocation helped soften the blow, but we still lost a good portion of the money, including our emergency fund.
Luckily, we never had to tap into the emergency fund and we were able to keep our jobs during the pandemic.
Lessons learned
- You can’t predict when stocks will rise
- You can’t predict when stocks will fall
- Your emergency fund should not be an investment and may be very well the things that saves you
Our advice is simple. Keep your emergency funds in a simple savings account at a bank/credit union or a money market account. In this way, when the smelly brown stuff hits the fan, you have a set amount of liquid cash available to use. It may be painful to see that much money just sitting in an account that is not even close to keeping up with inflation but remember your emergency fund is not an investment and is for emergencies only. If it is hard for you to look at it every time you look at your bank statement, then open another savings account separate from your bank and put it there so you don’t see it.
In 2023, we were finally able to efficiently move all our funds from the Betterment account to a savings account. It took a while because with Betterment being a taxable investment account, if we were to transfer the money back to the bank, this would cause the funds to be sold and we’d accumulate taxable capital gains.
Summary
In conclusion, it’s important to save and have an emergency fund for 3 to 6 months based upon your monthly essential expenses.
Remember, the emergency fund is not an investment and should not be treated as one. Placing the emergency fund in a savings account at the bank is sufficient since capital preservation is the primary goal.
If you are having trouble saving for an emergency fund, it might be time to look at increasing your income or decreasing expenses. Start small, even saving $10 per day or per month is better than nothing.
Discussing how to improve your personal finances is one of the things I discuss in myFREE Financial Independence Plan Frameworkguide that you can download below.
If you are serious about financial independence or are still thinking or learning about it, then you should get this free download. What do you have to lose? It’s FREE!
