by Christy Bieber | June 10, 2019
Having a hefty emergency fund is important to protect you against the calamities in life that are inevitably going to happen. These emergency funds need to be kept in easily-accessible locations, such as high-yield savings accounts. You don't earn much interest on these accounts, however, so while you need to make sure you have enough money in your emergency fund, you don't want to have too much.
It can be hard to tell when you cross the line from an emergency fund that's just right to one that's too big. These four signs suggest that you might have too much cash stashed away in case of an emergency.
Conventional advice says you need three to six months of living expenses in an emergency fund. But when calculating living expenses, this doesn't necessarily mean you have to maintain your current lifestyle -- it means you need enough to cover three to six months of spending on necessities if you're out of work.
If you currently earn a high income and live pretty large, spending hundreds or even thousands of dollars on entertainment, dining out, clothes, and other luxuries, you probably don't need to save enough to cover three to six months of your current spending levels. You could -- and should -- make big cutbacks to your lifestyle if you end up out of work or facing a serious medical issue.
When calculating how much to save for three to six months of living expenses, look at the essentials: rent or mortgage payments, debt bills, utilities, car payments, groceries, and other costs you'll need to continue to pay even if you lose your job or can't work. Figure out the amount you'd actually require per month if you did some cutting back, and save three to six months of that amount.
One of the primary goals of an emergency fund is to help you stay out of consumer debt. You don't want to have to charge unexpected expenses on a credit card or have to rely on credit cards if you experience a loss of income. That's why it can make sense to save at least a small emergency fund even when you're trying to pay back credit card debt. Otherwise, the first setback could send you right back into the hole again and erase all your progress.
Consumer debt also has a very high interest rate. If you have $10,000 in credit card debt and $30,000 in an emergency fund, it likely makes very little sense for you to continue paying a fortune in interest every month while your $30,000 just sits there. Especially because if you took the money out of your emergency fund to repay your debt, you could build it back up quickly once you no longer have monthly credit card payments to worry about.
If you have high-interest consumer debt such as credit cards, payday loans, or a car title loan, you should save a small emergency fund. This could be as little as a few hundred or a few thousand dollars depending upon your household income and the likelihood of an emergency. Then switch your focus to getting this expensive debt paid off ASAP. Once it's gone, start putting more money into your emergency fund until you have three to six months of living expenses saved.
An emergency fund should help you achieve financial stability -- not compromise your efforts at making your money work for you. If you find you're putting so much money into an emergency fund that you can't save for anything else, then you aren't doing yourself any favors. This is especially true if you already have three to six months of living expenses saved and you're continuing to funnel money into an emergency fund.
For your wealth to grow, you need to invest in assets that produce decent returns. For any money you don't expect to need within the next five years, this usually means investing in the stock market. Once you have a decent emergency fund that will cover you in case of short-term losses, it's time to start putting money you'll need for the long term into assets that allow you to make compound interest work for you.
If you have access to a 401(k) at work and your employer provides matching funds, contributing to this account should be one of your top priorities. If you're funneling money into an emergency fund and not maxing out your 401(k) to get your employer match, you're making a mistake.
This is another situation where you should build up a baby emergency fund of a few hundred or a few thousand dollars, contribute enough to get the employer match, and then put extra money into the emergency fund until you hit your goal of three to six months of living expenses.
Once you've got this much saved, you should seriously consider making investments in accounts that provide you with tax benefits instead of putting more money into an emergency fund. It makes little sense to continue to fatten an emergency fund that's large enough already instead of getting the tax benefits of investing in a 401(k), IRA, or health savings account.
There's no question that saving money for emergencies is one of the most important things you should do with your money. But while you need to protect yourself in case of job loss, illness, or unexpected expenses, you don't want to build such a big emergency fund that you compromise your other goals or miss out on a 401(k) match or tax-advantaged investing.
Be sure to look at the big picture when it comes to your money. Consider your family's income and how likely it is you'll need to draw from your emergency fund, evaluate your other financial objectives, and then make a fully informed choice about where you should put your money.
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