We hear a lot about the importance of having emergency savings, and it's all true. You absolutely need an emergency fund in case you fall ill, lose your job, or incur some major expense that you would otherwise be unable to cover. But while it's true that a frightening percentage of Americans are woefully unprepared for an emergency -- and over a quarter of U.S. adults have no savings at all -- the amount you actually need in your emergency account might be lower than you think.
The downside of emergency savings
The standard savings goal for an emergency fund is three to six months' worth of living expenses. Some recommend saving even more, especially if you have a family and are the sole breadwinner, or if you're self-employed and tend to have major fluctuations in income.
Ideally, you won't ever have to touch the money in your emergency account, or at least not all of it. For many folks, it's an insurance policy of sorts. But given today's paltry interest rates, leaving that much money to rot in a savings account means missing out on opportunities to invest it and let it grow.
Remember: You're not supposed to invest your emergency fund in securities, because their value can fluctuate drastically, and you want to be able to withdraw your emergency cash at any time without the risk of locking in big losses. But let's say you need $5,000 a month to cover your living costs and you manage to save enough to cover that "ideal" six-month target. Instead of investing that $30,000 and growing it into an even more impressive sum, you're earning minimal interest for however long that money stays put.
Here's another way to look at it: If you invest $30,000 in stocks and manage to generate an average annual return of 8%, then over 20 years, you can turn that balance into $140,000. But if you leave that money in a savings account that generates 1% interest on average, then after 20 years, you'll have an anticlimactic $36,600. It's for this reason that you might be better off sticking to the minimum emergency savings you need -- and believe it or not, we don't all need to aim for that target of three to six months' expenses.
When you can save a bit less
Let's get one thing straight: Many people do need three to six months' worth of living expenses in an emergency account, and some need far more. But here are a few scenarios in which you can get away with a smaller rainy-day fund:
- You're married and both spouses work. As long as you and your spouse don't lose your jobs simultaneously, you'll still have money coming in even if you find yourself unemployed or unable to work for a period of time. Just as importantly, there's a good chance you'll be able to jump onto your spouse's health plan, which could be less expensive than paying for COBRA or buying new coverage independently.
- You have a side job or secondary source of income. If you can't work due to an illness or injury, then having a second job won't be much help. But if you're laid off and have a side business to fall back on, then you'll probably have some money coming in as you look for work.
- You have a steady stream of investment income. While investment income shouldn't take the place of an emergency fund, it can be used to supplement your savings so that you don't have to leave quite so much money sitting in a low-interest bank account. If, for example, your portfolio is loaded with dividend-paying stocks and interest-paying bonds, then you can fall back on some of that income if you lose your job.
- Your company has a generous severance policy. If you know for a fact that your company guarantees a certain amount of severance in the event of a layoff, and you're certain you're eligible for that severance, then you probably don't need quite as much money in an emergency fund. Some companies only offer a few weeks of severance pay (or none at all), but if your company offers a payout that's worth, say, six months' salary, then you can use that money to stay afloat while you search for a new job.
Remember, too, that as long as you aren't fired for wrongdoing, there's a good chance you'll be eligible for unemployment, which will put a little more money back in your pocket. Of course, for some people, a well-padded emergency fund is a source of comfort, so if you'd rather err on the side of over-saving, it's certainly not the worst move you could make. Or, to put it another way, it's a far better option than saving nothing at all, as so many people do.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.