In most cases, having an emergency fund before you begin investing is the ideal situation. This is the mantra waived by nearly all personal finance writers. Often, they overlook complex situations simply because it is difficult to give a broad and comprehensive answer.
In some cases though, it would be in your best interest to start investing before you have a fully funded emergency fund. I will address a few of those cases in the second portion of this post.
How much money do I need in my emergency fund?
The amount of money that you need in your emergency fund can be dependent upon a bunch of personal factors. Normally, three to six months of living expenses is a good recommended amount. The emergency fund is intended to cover large, unexpected expenses or life events that can’t be foreseen. Examples include: Loss of income, medical emergency, emergency home repair, emergency car repair. I would recommend that someone have separate savings for regular home maintenance, car maintenance, and normal medical expenses. However, the emergency fund can be used for expenses such as maintenance if you have no additional savings. The emergency fund should be used to cover expenses that are above and beyond that amount. In the case of job loss, the emergency fund covers the loss of income which pays all basic living expenses.
You can adjust the amount needed to be saved to the lower end of the spectrum if you have a lower risk for certain emergencies. For example if you have two very secure sources of income in a family, it is less likely a single event will effect both income earners. This is most useful for those who work in different job sectors. Working at the same company as your spouse does not necessarily provide this protection. You may also need to adjust to the higher end of the spectrum if you have higher risks. For instance, if you have variable or unreliable income such as from independent contract work, or are a seasonal worker. In that case, six months of expenses or more would be a recommended standard.
The standard amount that I like to reference is six months of living expenses. However, I think using 3 months of living expenses is a good first goal, as 6 months of living expenses is a large sum of money for most people. If 3 months of living expenses seems extremely large, or you happen to have consumer debt, then I recommend following Dave Ramsey’s advice for how to save up that emergency fund.
This emergency fund money should sit in a high yield interest savings account or in certain highly liquid government savings bonds which can be cashed out at anytime on short notice. I will address these types of bonds in a later post. While most banks offer essentially 0% in interest, there are some online banks offering much closer to 1% such as Ally Bank (at the time of this writing). The most important thing is that the money is liquid, easily accessible when you need it, and insured from loss by the FDIC or government.
When to start investing
Begin investing once you have saved up at least a 3 month emergency fund. My recommended target is 6 months for a secure emergency fund. However, you can probably start allocating money to investments once you hit the 3 month amount, while continuing to grow the emergency fund.
There are a few exceptions to this rule:
- You work for a company that offers a 401k or similar savings plan, in which they offer a match on money that you contribute. In this case, it is important to contribute as much money as possible to reach the company match. Then, contribute the rest of your money to growing your emergency fund prior to investing more. Some companies offer a 50% or 100% match on your money, or more, which is essentially free money. This will be the highest returning investment you can make in nearly all situations.
- You are someone’s dependent, such as a young student who is able to start investing at a young age, while still being supported by their parents. In this case, putting some money aside early for investing is a good thing as your emergency expenses are covered by someone else. It is hard to predict a proper emergency fund size in this circumstance. Therefore, a nominal amount of saved money can be set aside for needs and the rest invested without meeting a three or six month target. I do not endorse investing if you are dependent on someone else for money in every other circumstance. After a certain age your first goal should be to become financial responsible for all of your own expenses without trying to make money investing.
- You have other means, besides high interest debt, to cover emergency expenses that can operate as a temporary emergency fund. Some situations such as a Home Equity Line of Credit (HELOC) at a very low interest rate, or similar circumstances can provide this opportunity. I do not recommend this route for the long-term, as nothing is a good substitute for liquid cash when it comes to paying for things in an emergency. In this case, if you are comfortable with the risk, you can start working on building your emergency fund and investing at the same time.
- You built up an emergency fund before starting to invest, then exhausted the emergency fund after you started investing. If you’re in this situation, you don’t need to sell your investments and empty out your investment accounts to refill your emergency fund. Continue investing, but use all new money to refill the emergency fund. The whole purpose of the emergency fund is to not force you to sell investments when it is a bad time to sell. This will help prevent you from losing money or having to pay large taxes.
In nearly every case, it is best to save up a three to six month emergency fund prior to beginning to invest. This is a very large achievement for most people. Recent data suggests that up to 62% of Americans don’t have money saved up to cover emergency expenses. If you’re in this situation, you’re not alone. I recommend doing everything you can to change that. Having a solid emergency fund is a crucial first step in becoming a successful investor.
How large of an emergency fund do you plan on saving? What has been your experience in balancing investing with building your emergency fund? Comment below so we call all learn from your experience.
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