You never know when a surprise expense or layoff might wreak havoc on your finances. That’s why it’s so important to have a solid emergency fund.
Data from the Federal Reserve reveals that only 68% of U.S. adults feel equipped to cover an unplanned $500 expense by tapping their savings. That means a good 32% of Americans are probably behind in the emergency fund department. As a general rule, most people need their emergency funds to be able to cover three to six months of essential living expenses.
But for some people, that may not be enough. And there are people out there who choose to maintain a 12-month emergency fund for added protection. But is that a sum you should aim for?
Not everyone needs 12 months’ worth of cash in the bank
The problem with keeping too much money in savings is that you lose out on the opportunity to grow it into a larger sum over time. A savings account might give you an average yearly 2% return on your money over several decades. But the stock market might give you an average annual 10% return.
Let’s say your essential bills come to $3,000 a month, only instead of settling for a six-month emergency fund, you sock away $36,000 to cover a full year of bills. Over 30 years, that extra $18,000 might grow into about $32,600 in savings if you earn an APY of 2.00% on it. But with a stock portfolio, assuming a 10% rate of return, that extra $18,000 might grow into $314,000.
That’s why you don’t want to overfund your emergency savings too much. Rather, it’s good to strike a balance.
If you’re someone with a typical job and typical expenses, a three- to six-month emergency fund will probably suffice. But there are exceptions.
When it pays to consider a 12-month emergency fund
There are certain scenarios where 12 months’ worth of savings is appropriate. For one thing, if you’re retired or on the cusp of retirement, it’s a good idea to have that much cash in the bank.
The reason? In retirement, you may have to tap your investment portfolio regularly so you have money to live on in the absence of a paycheck from work. If the market crashes, it would be a bad time to cash out investments. So if you have a year’s worth of expenses in savings, you’ll buy yourself that much time to ride out a stock market downturn without having to immediately lock in losses.
Another scenario where you may want a 12-month emergency fund is if you have a very unique job. Let’s say your job is to source coffee internationally. There probably aren’t too many people who do what you do. If you’re a bookkeeper or an engineer or a store manager, you probably don’t need a 12-month emergency fund. But if there aren’t many iterations of your job, then 12 months of savings is a good idea.
Finally, if you’re self-employed, you may want to consider a 12-month emergency fund in case a lot of your income comes from a few core clients and they all end up making budget cuts in short order. When you’re self-employed, you don’t get severance or unemployment benefits to fall back on, so extra savings may be in order.
All told, it’s smart to save adequately so you’re protected in the event of an unplanned expense or financial hiccup. But overfunding your emergency savings could cause you to lose out on the gains you might enjoy by investing. So don’t rush to amass a 12-month emergency fund unless there’s a good reason for it.
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