Today, we’ll challenge the popular advice of keeping an emergency fund of 3 to 6 months for financial emergencies. We believe that 3 months is simply not enough. A cash emergency fund plays a crucial role in your long-term financial plan, acting as a shock absorber that allows you to weather times of financial and economic uncertainty. This cash should be kept in a liquid account like a savings or money market account. Here at Copper Seed, we suggest aiming for at least 6 months of expenses in cash. We’re often asked why, so here, we share our reasoning.
The Purpose of a Cash Fund
A cash emergency fund is an important part of your long-term financial plan for 2 important reasons.
It’s a shock absorber in challenging times
While we can’t plan when an emergency will happen, we can be prepared. Cash set aside is available first for small emergencies like replacing the transmission in your car. If you have the cash on hand, you avoid using your credit card and incurring expensive interest payments paying it back over time.
But, more importantly, it’s available when you need to weather longer periods of financial hardship like a job loss. In these times, your emergency fund will cover several months of lost income. This prevents you from dipping into your retirement account and affecting your long-term financial stability.
It allows you to stay in a proactive financial position
Even more powerful is the fact that a properly funded emergency fund keeps you in a proactive position all of the time. It allows you to take your time finding the right employment opportunity, rather than taking the first offer. It also allows you to capitalize on opportunities that can arise in times of financial stability.
Why 3 Months of Cash is not Enough
The typical wisdom of keeping 3-6 months of expenses in a cash emergency fund is definitely a generalization. The actual amount varies for each of us, and we’ll discuss this more at the end of this post. However, most of us should have at least 6 months of expenses in cash for a few reasons:
A job search typically takes longer than 3 months
According to Bureau of Labor Statistics, in 2022 it took, on average, 5 months for a job-seeker to find employment. If you have at least 6 months of emergency savings, you’ll more easily weather this time.
A larger fund gives you more options
A sufficient fund allows you to feel less pressure in challenging financial times. For example, when looking for employment, you can allow yourself to wait for the right opportunity. Employment is a long-term commitment, and the decision you make establishes your path for future financial growth. So giving yourself the time, beyond the average 5 months, to make an informed decision is worth it.
Multiple emergencies can happen at once
It’s not unlikely that in that same 5 months you’re unemployed, you’ll have an unexpected, expensive cost–like a car repair or air conditioner replacement. These types of expenses could quickly reduce a 3-month emergency fund.
Determining the Right Amount of Cash
Because each financial situation is unique, we can take steps to better determine exactly how much cash we should keep in reserve. If you’re in a dual-income household or have multiple sources of income, then loosing one source is less devastating. But if you’re in a one-income household, you’ll need to a larger reserve.
Follow these steps to determine how much cash you should keep on hand:
1. Calculate your essential monthly expenses
First, determine how much you’ll need each month. You’ll need to cover essential costs like rent/mortgage, food, utilities, etc. Include required monthly debt payments like auto loans and credit card payments. Our article on budgeting will help you determine your monthly expenses.
2. Calculate your other sources of income
If your household has multiple income sources–a partner’s income, passive income from rental properties or other investments, or from a side-gig–all of these can offset monthly expenses. If you have a dual-income household, it’s safest to prepare for the loss of the larger income, so use the smaller income for this calculation. Total these other sources as an estimate of the income that you can continue to rely on each month.
3. Calculate the monthly income gap to cover
Take your monthly expenses and subtract the total income you identified in step 2. This remaining amount is the monthly gap you need to cover with savings. The more diversified your income, the less you need to replace each month.
4. Determine the total needed in your emergency fund
This final step is a 2-step process. First, multiply the monthly income gap you calculated in step 3 by the number of months you want your emergency fund to last. At a minimum, multiply by 6 for a 6-month emergency fund. Ideally, aim for 9 to 12 months.
Now, add any annual expenses, like insurance payments and property taxes, that could arise during a period of income loss. Also add any other large, impending costs, like a major repair on an older car. You should save enough to cover the total of 6 (or more) months of expenses and these additional annual costs.
This process allows you to more accurately cover an extended period of income loss while also being able to absorb regular annual expenses and other large expenses that are likely to occur.
Take it One Step at a Time
Saving this much can seem daunting. But you don’t have to do it all at once. It often takes a few years to build a sufficient fund, and you’ll balance this goal with other financial priorities.
Start by anticipating your next likely large expense. This could be a car repair, medical bill, etc. Save what you expect to need. This will prepare you for this impending cost.
Then, set your next savings goal–perhaps to have 3 months of expenses in cash. When you reach that goal, continue to the next until you have a fully-funded emergency fund.
If you need to dip into your cash fund to cover a large expense while you’re still building it, do so, and then replenish it as you can. Steadily, over time, you’ll build this necessary cushion.
To prepare for uncertain times, you certainly need to be saving. Show up for yourself today and tomorrow by taking the first step. Move into a proactive position to give yourself increased flexibility when choosing how to spend your time, energy, and money. Drop by drop, we are filling tomorrow’s cup!