Why do you need an emergency fund?

You may have heard that you need an emergency fund, but never understood why. An emergency fund is a crucial financial safety net that provides individuals and families with peace of mind during unexpected situations. Life is unpredictable; unforeseen circumstances such as medical emergencies, job loss, or urgent home repairs can arise without warning, potentially leading to significant financial strain. An emergency fund allows you to cover these unexpected expenses without debt. However, the money you need to keep in an emergency fund will vary depending on your situation.

The primary concern with an emergency fund is liquidity. Suppose someone has a net worth of $500,000, but can’t scrape together funds to pay for a $2,000 emergency. That demonstrates that they don’t have access to any of that capital, whether it be locked away in real estate, retirement accounts, or something else.

Your investments don’t qualify as an emergency fund. Neither do cryptocurrency, credit cards, or cash-value insurance policies. Rather, your emergency fund needs to be kept in a vehicle that you can get access to now. This almost always comes in the form of a money market account or bank account.

Why these two options? Because both options are very safe to keep funds and can be accessed very quickly. The reason people use money market funds is that depending on the interest rate environment, you may be earning a small amount of interest on the funds you keep there. It won’t usually be very high (hence why we invest excess cash into other vehicles), but it will at least be enough to slow the adverse effects of inflation on your account.

So how much money do you need to keep in this account? This is a far more important question than most people give credit for. Too little in the fund, and we will have to resort to debt for any emergency we might have. However, if we keep too much, that is considered “excess cash”, which is money that would be better used elsewhere. We want to balance this amount as much as possible.

There are a couple of different situations someone may find themselves in, each would warrant a different approach. For example, if a married couple has no children and each spouse is working, it would be justified to have less in an emergency fund because most likely, their living expenses are low compared to the amount of income that they are both bringing in. A couple like this could probably get away with having around 3 months of living expenses set aside in an emergency fund.

However, now let’s look at a single-income family with children. There are a few more variables at play here now. The first is that there is only one job to lose. This means that in our example before if one of the spouses lost their job, they still had the income of the other to rely on while the spouse sought out new employment. However, with a single-income household, the family will need to rely on the emergency fund during the transitionary period. This is why you often hear the “6-month rule” thrown out. Because to effectively cover any emergency and replace income during job transitions usually six months of income will be enough.