Many people with, or trying to pad, an emergency fund are making a basic mistake, says Ben Carlson, a CFA and the director of institutional asset management at Ritholtz Wealth Management, because they're using that fund to handle predictable or regular expenses — ones that can actually be expected, rather than a true crisis.
Before you start contributing to an emergency savings account, he says, "you really have to decide what constitutes as an emergency." That's because "oftentimes the stuff that goes wrong you can actually plan for," Carlson says. Replacing a busted tire can feel like a surprise, urgent expense, for example, but car maintenance is an expense you can budget and earmark cash for in a separate, specifically named savings account. The same is true for a one-off expense like having to buy someone you love a wedding gift.
"Setting aside a little money each month for infrequent but predictable costs can take away some of the sting when something unexpected does come up," Carlson says.
The good news is that if you approach emergency funds this way, you may not need as much money as you've heard to feel secure because you'll only need to tap your fund for a true emergency. The amount to set aside for a crisis "depends on your personal situation," Carlson explains. "Maybe it isn't six months [worth of expenses], but two months."
Here's how he suggests personalizing your emergency saving plan.
Before you figure out how much you should be allocating to an emergency savings fund, Carlson suggests defining what an emergency means to you.
Job loss, for example, is pretty universally considered a financial emergency. But some people are at greater risk for loss of income than others. "If you have a government job, that may be a little safer. If you're a teacher and you have tenure, those are the kinds of positions where you may not need as big of an emergency savings account," he says.
If your income is more variable, or if you work in an industry with a challenging job market where it might be harder to land your next gig, you should have more of a financial cushion, "like for someone who works in sales or some other industry where your income is more volatile," he explains.
If you have a more stable profession, you may not need to have an emergency savings account that amounts to half a year's worth of savings. "Circumstances matter. How you approach the idea of a financial emergency in the first place matters. Your other financial backstops matter. And your preference for risk matters," Carlson wrote in a recent post on his blog "A Wealth of Common Sense."
Review your expenses from last year to figure out how to allocate savings to "specific buckets," Carlson suggests. This can help you prepare for both predictable and unpredictable costs.
If you look back on your finances from 2020, take note of the purchases you spent the most on and try to foresee some of the unexpected costs that may pop up in 2021. For instance, if you have a pet, you may want to allocate money to help cover an emergency vet visit by saving a little bit each month, he explains.
Video by Stephen Parkhurst
Reviewing big ticket items from the prior year can help you determine how much you need to save in case of an emergency. "If you know every year you're going to spend $800 bucks on car maintenance, then you can set aside $40 or $50 a month to cover something like that so it doesn't have to be this big thing where you're scrambling," Carlson says.
Allocating money towards predictable costs can also help you avoid high-interest credit card debt, which is often an option people with no emergency savings have to resort to, he says.
Before tapping into your emergency savings account, explore all of the other options available to you. "If you're saving 20% of your income a month, you can slow the savings down to pick up some of the slack" before draining your emergency savings account, Carlson says.
Another option to consider is a credit card with no interest for the first year or more, "with the understanding that you'll have to make the monthly payments and pay off the balance before the no interest period is up," he explains.
Financial experts generally recommend a much more robust emergency savings account, it's worth noting: The rule of thumb is to have at least enough to cover 3 to 6 months' worth of expenses. And personal finance expert Suze Orman recommends stashing away 12 months' worth of expenses.
The amount of money you save for an emergency "depends on your risk appetite," Carlson acknowledges. But the more money you have sitting idle in a savings account, the more money you're not using to build wealth: "That money isn't growing, especially since interest rates are so low." And money in a savings account is missing out on the power of compounding interest.
A little planning can help you customize your emergency savings plan and allocate your hard-earned cash wisely, Carlson says. "It's really just about having your financial house in order to figure out where you can pull money from if you need it."
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