Emergency Funds: How Much Cash Is Enough?

Identifying how much cash is enough for our emergency funds is not always straightforward. To avoid the perils of too little or too much cash, here’s some guidance to help determine the right amount for you.

Holding an emergency fund is a vital feature of sound personal finance management. Unforeseen events and circumstances can create a sudden need for spare cash. And if we don’t have enough cash to service these emergencies, we risk finding ourselves in deep financial trouble.

Unemployment, for example, can take us by surprise if we’re financially complacent. And unexpected bills can jump up on us, like big service and repair costs for unexpected problems with boilers and vehicles. Whatever the emergency, we need enough cash to cover it.

But if we hold too much cash, we’re foregoing potential gains from other asset classes – so there’s a balance to be found here.

The general advice is that we should hold a cash amount equivalent to 6 months of living expenses. This might sound a hefty chunk of cash, but it could be the necessary protection required in the event of a recession or significant unexpected one-off cost.

What should be considered as living expenses?

To establish the amount for a 6-month emergency fund, let’s consider what generally makes up living expenses.

In short, living expenses are the necessities that you must cover to get by in the event of an emergency. Necessities clearly don’t include the discretionary expenses you might have during economic good times, like movie tickets and meals out at restaurants. So think needs and not wants as you go about calculating your living expenses.

Typically, living expenses include items like the below:

  • Mortgage repayments or rental costs. Unless you’ve paid off your mortgage or are lucky enough to have free accommodation, this is a fixed expense that must be included in your calculation of living expenses. If you’re on a variable rate mortgage, it’s sensible here to include a flex in your calculation to accommodate realistic interest rate hikes. If you’re a renter, make sure you include the full scope of your charges, inclusive of items like maintenance fees.
  • Utilities and local taxes. Electricity, gas and water costs, though controllable to an extent, are unavoidable – and so they should be factored into living expenses. Living at a property also comes with local council tax fees, which is a fixed cost that again can’t be avoided.
  • Groceries. We need to eat and drink to live – so this one isn’t rocket science. Work out what you spend on food and other supermarket essentials per month. Again, grocery costs are controllable to a point, but unavoidable at a certain level, so these must be included in the calculation of living expenses.
  • Non-discretionary travel. If you travel to your workplace and have no other option but to pay for the costs of travel, these clearly need to be included in your living expenses calculation. Think about your fuel costs, road tax, train tickets, parking costs – anything unavoidable in your day-to-day life.
  • Other regular bills and spending. Work out how much you spend on other contracts per month that you’re tied into or not willing to cancel. Mobile phone contracts, broadband internet costs, car insurance, home insurance. Whatever the costs, if you cannot or are unwilling to cancel them, they need to be included in the living expense total per month.
  • Contingency. Include a buffer in your calculations for price hikes and other costs you may not have factored into the above categories.

Calculating an emergency fund target – a quick example

Let’s pause for a second and work this through with a quick example.

Mr. Savvy wants to calculate his target emergency cash fund. To calculate his emergency fund target, he needs two things:

(1) a figure for his monthly living expenses;

(2) a figure for the number of months he wants to cover in his emergency fund.

Mr Savvy’s Living Expenses

Mr Savvy wisely tracks and monitors his spending and so has the data he needs to calculate his living expense readily available. He then simply multiplies his monthly living expense total by 6 months to get to his target emergency cash fund. Voila!

When is 6 months of living expenses not enough?

But there’s a caveat here. 6 months of living expenses is not necessarily the optimal amount for everybody. The question of the right number of months generally depends on the risk of income loss.

If we have several income streams as well as a stable job, we might have more flexibility to reduce our number of months in the emergency fund. On the other hand, there are some circumstances that may demand a higher number of months in the emergency fund.

#1: Recessions and unemployment

The risk of unemployment is magnified during recessions. And here’s the bad news: recessions are inevitable. If we find ourselves unemployed during a recession, it can be more difficult to find something else. After all, other businesses in our lines of work will be laying people off too.

So it’s important to consider if 6 months is enough of a buffer for you in the event of a recession. This will depend on your industry, line of work and type of contract, amongst other factors. And this needs to be evaluated objectively. Get a strong sense of the risk factor in your industry and line of work and adjust your months of protection accordingly.

But there’s a second good reason to hold more cash in the event of a recession. They bring about opportunities in the form of lower asset prices. And by topping up our emergency cash funds, we’re better placed to capitalise on market opportunities and reinvest in asset classes at a lower buy-in point.

#2: High risk industry for layoffs

Aside from the unemployment risks brought about by recessions, some industries simply carry a high risk of layoff in general. If you work in such an industry, you’d be wise to think about holding a higher amount of cash in your emergency fund. This provides additional protection against potential volatility in employment, even in good economic times.

#3: Inconsistent income sources

Equally, if income sources are inconsistent, there’s further reason to hold a higher amount in our emergency funds. Contractors, for example, may not have a reliable source of income and generally do not have the same level of rights as permanently contracted employees. This means that not only is general income level less stable, but there is no potential for severance in the event of job loss. So again, this is all a question of protection against risk to income.

#4: Nearing or in retirement

As we near or enter retirement, it’s wise to move our financial portfolio towards cash and lower risk asset classes. Our ‘emergency fund’ of cash is therefore likely to be bigger than 6 months. This is a typical de-risking cycle that pension funds adopt as we move towards our specified retirement age. But it’s also worth thinking about with our accessible wealth.

The upshot

6 months’ cash is a general rule of thumb – and not a silver bullet. Circumstances play a big part in determining cash requirements. More or less than 6 months may be advisable in different circumstances. So it’s important to closely and objectively evaluate your own risk factors.

If you’re some way from getting to 6 months of cash in your emergency fund, start small. Target a couple of months to begin with and then slowly de-risk as you begin to accumulate more cash. While a smaller emergency fund can leave us a bit exposed, we all start somewhere. The key is not to panic. Patient saving, intentional spending, and diligent working will quickly close the gap.

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