Most people have a level in mind of how much money should be on hand in savings or checking so they feel comfortable. This cushion can vary widely from person to person based on their own life experience and what feels right. As a practical matter, I believe that 3 to 6 months of a person’s living expenses (not their income) is what should be in an emergency fund. If they are a couple, with both working, they could probably lean closer to the 3-month range. If they are a single person, or single breadwinning family, I would recommend closer to the 6-month level.
This emergency fund is what should be on hand, in safe and stable accounts, like a savings account, to handle any unforeseen events that may come up; a simple car repair, a new furnace in the middle of winter, a job loss, or an uncovered medical expense. As we all know, life happens and is filled with the unexpected.
Speaking of the unexpected, according to a recent Bankrate Survey 6 out of 10 people in the U.S. lack the savings to handle an unexpected $1,000 expense. This is a small amount of money (when thinking of the unexpected) and this is a lot of Americans. This lack of preparation is one reason people put silly things on credit cards and why they never seem to make forward progress. They have an anchor of debt holding them back.
On the other hand, we often see people with up to four- or five-years’ worth of their expenses sitting in their savings account at the bank. I am not telling you anything you don’t know when I say they are earning next to nothing on that money. It is not uncommon for these accounts to pay as little as .25% interest on deposits. We have seen several hundreds of thousands of dollars sitting in savings accounts because it gives a sense of security if anything unforeseen were to happen. First, I can’t imagine what could happen that would require that kind of money. Are you suddenly needing to buy a house or a fleet of cars? Second, I think of what that money could be doing if it were put to more productive use.
Let’s do some simple math. If inflation is averaging 2.0% and you are earning .25%, you are losing purchasing power each year, and mathematically we can quantify the amount in real dollars. $200,000 earning .25% would add a whopping $500 after one year. Meanwhile, it would need to have earned $4,000 just to keep pace with inflation ($200,000 at 2% inflation). This cushion, this comfort level, this emergency fund, whatever you want to call it, ended up costing $3,500 ($4,000 minus $500), and that is just to keep even and not move forward.
It occurred to me, when I encounter this situation, these people don’t have a cushion, they have a mattress store, and it is costing them real money every year. Of course, they may still feel comfortable with the mattress store, and if it helps them sleep at night (pun intended) then who am I to suggest something different? It is, however, incumbent upon me to point out the mathematical situation and suggest alternative ways to consider addressing their comfort.
If you are reading this, and you don’t have a mattress store, please start by getting your cushion of 3 to 6 months of living expenses in an emergency fund. Make this a top priority. Doing so will put you in the top 40% of people in the U.S., and I think that’s where you deserve to be.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.