Is There Such a Thing as Having Too Much Emergency Savings?
We all need emergency savings for life's unknowns. But how much money in the bank is too much?Image source: Getty Images.
Life has a way of throwing unwanted financial surprises our way. You never know when your car might break down, your roof might spring a leak, or your boss might march into your office and tell you that you're out of a job. That's why we all need emergency savings to cover life's many unknowns. Without money in the bank, we risk racking up debt the moment an unplanned bill pops up.
That said, there is such a thing as having too much money held up in cash. While it's better to have an overfunded emergency account than no safety net at all, tying up too much of your money could hurt you in other ways.
How much emergency savings do you need?
Financial emergencies can run the gamut from an unanticipated $500 expense to a $5,000 medical bill. Long-term unemployment can be even more costly. That's why, as a general rule, it's wise to sock away enough money in savings to pay for three to six months' worth of living expenses. The logic is that this sum should cover you in the event of either a major bill or lengthy period of unemployment.
Obviously, the closer you get to that six-month threshold, the more protection you'll buy yourself. If, for example, your income is somewhat variable, you have kids, and you own a home that's prone to needing repairs, then six months of expenses should probably be your savings target. On the other hand, if you're single with no dependents, you don't own a home or car, and you've been at the same job for a decade or longer, you might get away with saving just three months' worth of living expenses.
But what if you want more protection than a six-month cushion? Should you sock away a year's worth of living expenses, or even more? Tempting (and seemingly responsible) as it might seem to build an even larger safety net, having too much money in the bank could actually constitute a financial setback.
Don't go overboard
The money you set aside for emergencies should be tucked away in an FDIC-insured bank account, where your principal of up to $250,000 per depositor is protected from losses. This means that if you typically spend $5,000 a month, and you decide to build a six-month emergency fund, your $30,000 can't lose value in an FDIC-insured bank. Furthermore, that money will be instantly accessible when you need it.
The downside, however, is that savings accounts pay much lower interest rates than what you'd typically get by investing your money instead. If you stick $30,000 in a savings account, you might score a 2% interest rate, thereby earning $600 on that deposit your first year. But if you were to put that money into a traditional brokerage account, you'd have an opportunity to invest it and generate a much higher return.
How high are we talking? If you invest heavily in stocks, you might easily score an average annual 7% return on investments over a seven-year period or longer (in the short term, returns are much less predictable). Going back to our $30,000 deposit, that means you could be looking at $2,100 in growth your first year instead of a mere $600 in interest.
The drawback of a brokerage account is that your principal isn't protected. If the market declines and your investments drop in value, you'll face actual financial losses if you sell at a time when they're down. That's why you can't keep your emergency fund in a brokerage account -- because you need to be able to access it in a pinch without having to worry about taking losses on your principal, and only a savings account offers that protection.
On the other hand, if you keep too much money in the bank, you risk losing out on potential growth that could change your long-term financial picture for the better. Over a 30-year period, the difference between an average annual 2% return on a $30,000 sum versus a 7% return is a whopping $174,000. Giving up that difference on $30,000, or six months of living expenses, is worth it for the peace of mind of not having to risk racking up debt. Unless you have a truly unique need for emergency savings, you shouldn't forgo that added growth on more than six months' worth of money.
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