I have lived most of my life on financial edge. First it was school, then it was contract jobs. There was never a moment of financial stability until about 2 years ago when I transitioned into full-time employment.
In that time between steady job and what felt like drifting, I was a hoarder. I’d save as much as my pay check as I could and stick it in a savings account, watching it grow a measly 0.5% at the time (this is pre-discovery of Tangerine and EQ Bank). My savings allocations were basically 100% emergency fund, 0% investments.
Then when that full-time employment came, I realized 0.5% interest wasn’t going to do it. After all, inflation is 1.5% – why lose money by inaction? It was then I made an active decision to begin investing while also strategically downsizing my emergency fund, which now comfortably sits at 3 months’ worth of expenses. How did I decide 3 months worth? By asking myself five basic questions related to my current financial status and short/medium term goals:
How much debt am I carrying?
Luckily, this was $0.00 for me through aggressive savings, scholarships, and parental help for my first degree’s tuition. But if you carry student or consumer debt, you should probably axe that as soon as possible.
The average rate on student debt is 3.5% while the average rate on credit cards can be as high as 30%. So sure, while you may be able to beat those interest rates by having money in the market (less likely with credit cards), remember that’s a speculative investment on your part. Think of it inversely: a student debt repayment is a guaranteed 3.5% return, since you’re foregoing an interest payment down the line. Take the guaranteed return over the speculative one.
How stable is your job?
If you’ve cleared your debt, this is the next question as it will help determine the size of your emergency fund. The literature out there commonly suggests three to six months worth of expenses is a good emergency fund, but that can be a wide range. If you spend $2000 a month, that’s a $6000 difference in savings to put aside.
I argue that the size of your emergency funds depends first and foremost on your job’s stability. If you’re in the public sector, you probably don’t need a full six months, whereas if you’re a contractor, you probably do. And if you have no job, you should cut costs where possible and see what supports exist around you, which leads me to…
How strong is your support network?
I’m not a fan of asking others for help, but your support network does a big part in dictating how much you really need in your savings account. You may have parents that would be okay with you moving home for a period of unemployment or a spouse that could support both of you for a short period of time.
But don’t treat the support network as your guaranteed fallback. Instead, adopt the concept of financial divorce: pay everything yourself for as long as possible without infringing on other people’s finances. If you are employed but are spending what you save with reckless abandon because you know mom and pop will always be there, you’re approaching the whole concept of support network wrong.
A support network goes both ways. In the case of your parents, you never know when you’ll need to help finance elderly care or sudden medical emergencies. Likewise, for your spouse, you never know what could happen when it comes to their employment status in the ruthless capitalist world. By financially divorcing yourself from others, your accumulated emergency fund can serve its true purpose: financing emergencies, wherever they come from.
How much money can you stomach losing (temporarily)?
If you’re answer is 0%, you probably will want to have all your money in cash – but this is not wise. Generally, if you could stomach a 50% drop in your money’s value, you could go 100% into the market and carry no savings, but this is also unwise since in an emergency, you could be selling your assets at a 50% discount in a recession plus incur unnecessary trading costs.
Your emergency fund is a matter of risk tolerance. In my opinion, it’s always wise to have something there that gives you the ability to tolerate risk, whether or not a risk event happens in your life. Financing the potential for bad news is always smart. Being unprepared isn’t.
ADDENDUM – Never use your emergency fund for things that aren’t emergencies.
At no point should you ever tap into your emergency fund for a large purchase. For example if your emergency fund is $10,000 and you’re going to spend $2000 on vacation, make your savings account total $12,000 before you leave. Don’t steal from your safety net to finance the pleasures of life.