Emergency Funds – How Big Of A Reserve?

An emergency fund should obviously be reserved for bona fide emergencies: serious illness, loss of job and so on. It should never be borrowed for such relatively unimportant uses as the purchase of a car, house or Flat Panel LCD TV. It should not be loaned even to close relatives except in cases of dire need.

As to how big the fund should be, an old rule of thumb says a family should be able to live for six months if its regular income were cut off. Interpreted conservatively that would mean that a family’s liquid savings, minus its short-term debt, would equal one half its annual take-home pay. Interpreted very liberally, it might mean that a family should be able to lay its hand on enough cash by various means to live six months.

In addition to liquid savings, certain other assets might be counted: cash value of life insurance policies, stocks conservatively valued, the amount invested in a 401K retirement plan. However, there are dangers of this practice. The cash value of a life insurance policy might be needed to keep up premium payments. Stocks might go so low, in a the recent recession for example, that it would be a shame to sell them. The amount vested in a 401K fund might be obtainable but with penalties attached. So for defense against a financial crisis, a family should certainly rely largely, if not wholly, on liquid savings.

There are four qualities you want your savings to have. Remember we looked at if an Emergency Fund was an “investment” or not. These qualities will pretty well determine where the money is to be kept. Listed in order of importance, they are:

Safety – You want your money to be reasonably secure against depression, panic and theft.

Liquidity – You want to know that you can withdraw your savings without too much delay.

High earnings rate – You want your money to earn interest at as high a rate as possible consistent with safety and liquidity.

Convenience – You want your savings to be located where you can take care of them with minimum trouble.

No one institution provides the maximum safety, liquidity, earning rate and convenience all in one package. It would be nice to have a place right across the street that would keep your savings completely safe and entirely liquid, while paying 15% interest. Naturally there is no such place. To get a high interest rate you must sacrifice some other advantages, such as liquidity. To have your savings instantly available you must be prepared to accept a lower interest rate.

It may be best, therefore, to split up your cash and put it in several places.

In general, we have found a tax-free money market account to be an excellent place to park money for our emergency fund.

How about you? Do you have an emergency fund? If not… get started today!