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The “Emergency Fund” Rule of Thumb is Broken

I have a problem with how we view the “emergency fund” and I believe that there is a better way to think about emergency savings. Recently, Forbes ran an article discussing how much should be in your emergency fund – the money set aside to cover unexpected expenses (such as car repairs, home repairs, and healthcare costs) instead of putting it on a credit card.

The article basically restates the old rule of thumb:

Keep 3 months of take home pay set aside if you are single, a renter and have a steady paycheck.
Keep 6 months of take home pay set aside if you are married, have kids, and have a mortgage
Keep 9-12 months of take home pay set aside if you are married, have kids, have a mortgage AND have variable compensations (such as anyone in sales).

Below are my list of grievances:

  1. The calculation should not be based off of take home pay, rather it should be based off non-discretionary expenses (3, 6 or 9 months of non-discretionary expenses). These are the required expenses that someone must pay, such as food, electricity and the mortgage payment. If someone lost their job, chances are they would tighten their belt and do some penny pinching to stretch their savings.
  2. Keeping the entire emergency fund sitting in cash, earning nothing is a real problem. When you factor in inflation, the emergency fund actually loses value. It’s costing the investor to keep money sitting on the sidelines.
  3. Why does the money need to be sitting in a bank account at all? There are many tools and resources available to investors that could be better.
  4. Emergency Funds tend to become a hidden crutch for the investor. Instead of taking the time to plan for future and known expenses, many investors rely on their emergency fund to cover these sort of expenses. An investor shouldn’t be too surprised that their 25 year old roof will need to be replaced soon and that their 10 year old car will require more maintenance.

Here is a simple tweak that could make an investor’s Emergency Fund a little more productive:

Follow the rules of thumb outlined above to find how much should be in the Emergency Fund. Any amount over $50,000 could be invested in a specially designed conservative portfolio of low volatility stocks and/or target date maturity bond funds. It remains readily available, but continues to grow and be a productive asset.