We Fools are often asked: Do I really need an emergency fund the size of three to six months' worth of living expenses?
Our answer: possibly.
It's certainly smart to have some emergency funds available for unpleasant surprises that occasionally rear their ugly heads. (Your employer relocates to Siberia and your spouse isn't keen on moving, so you're out of work. Your child is discovered to be a tuba prodigy and you suddenly need to cough up a lot of money for costly Tuba Camp -- and a costly tuba.)
Three to six months' worth of expenses is a sensible amount, but depending on your situation you might want to keep a little more or less. If you know you aren't likely to have much trouble getting a new job or earning more money when necessary, you might not need to keep too much on hand. If you have many dependents, or don't always find new work too quickly, then perhaps consider keeping a larger stash on hand.
Remember not to park any emergency money in stocks. In the short run, anything can happen in the stock market. Keeping that moolah in a savings account that earns little interest isn't so hot either. Fortunately, you have other options. You could keep the money in a money market fund, which will pay you more than a savings account. You might also park the money in short-term certificates of deposit (CDs) or bonds, perhaps laddered so that a portion of the money is always close to maturity.
Here's another option -- likely a controversial one -- if you don't have much credit card debt. You might decide to charge expenses on your credit card, up to a certain amount, if you run into temporary trouble. However, be very careful with this approach. If you keep a significant balance on your credit card and you're charged a steep interest rate, a bad situation can quickly get much worse.
Loans are another possibility. If you have family members or close friends who could easily lend you enough to cover your temporary needs, that could work out well. If you own your home, you might be able to take out a home-equity loan to generate some temporary cash.
If you have a brokerage account chock-full of stocks, you might be able to borrow what you need from your brokerage, on margin. People usually borrow on margin from brokerages to buy addition stock, but you can borrow for pretty much any purpose. Your portfolio serves as collateral. Just be careful -- if you borrow a lot and your stocks suddenly plunge in value, you'll be hit with a "margin call" and may end up losing some of your stocks. We recommend only using margin sparingly, if you use it at all.
If you have a 401(k) at work, you might be able to borrow against that in an emergency, too. And here's another controversial idea: Use a Roth IRA as an emergency fund.
The main idea behind these unconventional alternatives is that, by counting on one or more of them, you'll not have to keep a sizable chunk of money tied up where it's not earning much for you. You can concentrate on building wealth, while having a solid plan for emergencies.
Again, be careful -- planning to tap retirement money or establishing significant credit card debt can end up making matters worse in the long run if you're not able to recover quickly. If these options make you nervous, then stick with the more conservative alternatives. Learn more in our Savings Center, where we also help you find attractive rates on CDs and money markets.
