How Big Should My Emergency Fund Be, and Where Should I Stash It?

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According to the latest news on Friday, President Trump has decided to call a three-week cease-fire in his wall battle with Congress, which will certainly come as some relief to the hundreds of thousands of Americans -- federal workers, contractors, and others -- who weren't paid during the 35 days of the government shutdown. And beyond those directly affected, millions more took hits to their income from the knock-on effects: Government workers without income reined their spending back to bare minimums, and billions of dollars in purchases never happened. All of which is a darn good reminder that no matter whom you work for, and no matter what you do, you need to have an emergency fund, because stuff happens.

In this segment from the Motley Fool Answers podcast -- recorded before we had any idea how much longer the shutdown would last -- hosts Alison Southwick and Robert Brokamp cover the basics: How big should your emergency fund be, and where should you keep it -- not in your mattress, but not in stocks, either.

A full transcript follows the video.

This video was recorded on Jan. 22, 2019.

Alison Southwick: Because of the government shutdown, roughly 420,000 Americans across the country are going without pay and have missed, at this point, at least a couple of paychecks. Imagine going a month without any income. Would you still be able to pay the bills? Most people wouldn't. As Bro has mentioned before on the show, 40% of U.S. adults don't have enough money in savings to cover a $400 emergency, so now seems like a really good time to have an episode dedicated to building an emergency fund and what to do if you don't already have one.

Robert Brokamp: Right.

Southwick: Bro, where do you want to start?

Brokamp: I talked about this a little bit in the last episode. People have been focusing on the [federal employees' problems due to the shutdown]. Some people are saying they'll get their money eventually, but this is affecting an estimated 4 million contractors, and there are so many businesses that are built around the federal government [suppliers, restaurants, cab drivers, service providers]. They're not going to get paid. They're just missing out on their business.

We here at Fool HQ are in Alexandria, Virginia. We're in the suburbs of Washington, D.C. We all know people who are being affected by this, including spouses of Fools, so it is pretty widespread, and there's no question that the economy is going to take a little bit of a hit because of this. Standard & Poor's estimates that very soon the cost of the shutdown is going to exceed the cost of the wall that President Trump wants, so it's kind of crazy.

The bottom line is a lot of people [must] have thought, "Well, I'm a government employee. I have a safe job." An example is the people in the Coast Guard. Fun fact -- I was accepted into the Coast Guard Academy. I was thinking of going into the Coast Guard and flying helicopters. Instead, I decided I wanted to be a priest so I didn't go. And we see how that worked out. But you think if you're in the Coast Guard your paycheck is safe, and this happens.

What it goes to show is no matter what situation you're in, something unexpected could happen, and the solution to that is the big old boring emergency fund. It's the most standard advice from all financial planners, but it just shows the need for it. If you don't have that emergency fund, you'll have to rely on other sources for the funds. We're going to talk about those later in the show, and the pros and cons of each option, but all of them are inferior to just having some cash on the side.

First of all, let's talk about why you would have an emergency fund. Talking about the shutdown, it's income disruption. It could also be an unexpected expense [home repair, car repair, medical bill] that you didn't budget for. That's a reason why you would have an emergency fund.

What should the size of the emergency fund be? We've always said three to six months of must-pay expenses. It's not three to six months of income, or three to six months of expenses. It's the must-pay expenses.

Southwick: Not Netflix.

Brokamp: Not Netflix.

Southwick: You may feel like that's a must, but it's not.

Brokamp: I've been saying that for years because that's what I've always heard for years, and I was wondering where that came from. Was there one person who was the first person who said that and is given credit for it? The answer is I couldn't find an answer to that.

But while that's the consensus on it, there is a bit of disagreement. First of all, there are people who think three to six months is too much. You have other ways to pay bills and again, we'll talk about those in a little bit. But some people do think that by having that much cash on the side you're missing out on opportunity costs [what you could have gotten if it were in the stock market or the things you could have spent it on and had some fun]. I don't agree with that, but there are people who believe that.

Then there are people who believe it should be bigger. Suze Orman thinks it should be eight to 12 months of expenses. David Bach, another well-known personal financial writer, thinks it should be at least a year, and his emergency fund is two years.

Is there any empirical evidence for the size of an emergency fund? Bankrate just came out with a survey that asked people, "Have you had an emergency and how big was it?" They found that 30% reported that either they or an immediate family member have experienced one major unexpected expense. The average of that expense was $3,750 and more than one-third was more than $5,000. That says, right there, that based on that evidence, a good emergency fund should at least be $4,000 to $6,000.

And what about the income disruption? That's usually because you've been laid off in most situations. I looked at that and right now the average duration of unemployment in the U.S. is nine weeks, or a couple of months. That's about the long-term average. But when you look at things like the Great Recession of a decade ago, that spiked to 24 weeks, so on average the unemployed person was out of work for one-half of a year.

In those types of situations, I don't think you need an emergency fund for those outlier experiences. That was the worst economic downturn since the Great Depression, but it definitely makes sense that when you look at the average unemployment of being more than two months, three to six months is not a bad guideline.

We should point out that one of the reasons why some people think you don't need that big of an emergency fund is because when you've been laid off, in many situations you get severance pay. The average severance pay is one to two weeks for every year of service. If you've worked for a company for five years, you could expect severance pay of five to 10 weeks.

Southwick: Not here at The Motley Fool.

Brokamp: Yes, it's a little more generous. I've heard discussions of it not being quite so generous. One thing I think everyone should do is find out your own company's severance package. And in the case of the Enrons, the WorldComs, the Lehman Brothers, and all those situations, many of them went out of business. I don't know the exact details for each of those companies, but in many situations when a company goes under, you lose your job and they don't have money to pay severance.

There's also unemployment benefits -- those are run by each state -- but the maximum they pay per week is pretty low. The average across the country is $400 per week, so $1,600 per month. Not a lot of money. Better than nothing, but not a lot of money. Those federal employees might be wondering if you can apply for unemployment benefits? Depending on the situation the answer is yes...

Southwick: Oh, good.

Brokamp: ...but if you then go back to work and you get the back pay, you have to return the unemployment benefits. That might be fine.

Southwick: A loan...

Brokamp: Maybe you just need something to get you there. But certainly for people in that situation it's something to look at.

The bottom line -- what should the size of your emergency fund be? I still stick with the three to six months must-pay expenses. The type of situations where I would say you need more would be if you have big, nonnegotiable expenses like a mortgage or a car loan. I have a big family. I don't have extended family who can help me. And I have a job that is more likely that I'm going to lose it during the next downturn or at least my pay will somehow be affected by that. Those are all factors that you would use to determine the size of your emergency fund.

What should it be in? Cash, plain and simple.

Now these days you can get a higher yield. The Motley Fool has a website called The Ascent where you can find some good yields. CDs, now, are actually paying upwards of 3% and some over 3%. Those are worth looking at. Just know that if you're going to buy a CD, you're supposed to keep it until the duration [a two-to-three-year CD]. You want to know the CD's policy if you need to cash it in early. Usually it's something like three to six months of interest. You want to know that beforehand.