You did it. You saved up enough money to cover three to six months’ worth of living expenses for that rainy day. This likely took some work and budgeting on your part, so you should be proud of yourself.
But now what should you do with the extra cash you’re saving? Would it hurt to continue putting more money into your emergency fund?
Actually, it could. There’s such a thing as having too big of an emergency fund, which typically means you’re not taking advantage of other financial opportunities. To better understand this concept, let’s see how emergency funds work and what might happen if your fund is too big.
What should your emergency fund cover?
Financial experts often recommend putting enough money into savings to cover three to six months of expenses in case of an emergency. This is a good rule of thumb, but it’s important to note that these expenses should typically only be necessary expenses. That means food, utilities, and housing, but not vacations, entertainment expenses, or money for going out to eat.
Because everyone’s financial situation is different, the amount of money each person should put into an emergency fund will vary. Nonetheless, a three-month, six-month, or 12-month emergency fund may be right for most situations. Here’s what you need to know about each of these funds.
Three-month emergency fund
A three-month emergency fund might work if you’re confident that you could quickly reduce certain expenses if needed. Having multiple sources of income in case of job loss, such as a side hustle or a partner who works, will also help. A three-month fund can also work if you have other sources of savings or investments that could be accessed in an emergency.
Six-month emergency fund
Six months of money in an emergency fund is a good savings goal if you feel you need more than three to replace lost income. This might be the case if you’re a contract worker rather than a salaried employee or if you support multiple dependents.
12-month emergency fund
A 12-month emergency fund may be a safer bet if you think it could take many months to secure another source of income. If you’re the only source of income for multiple dependents and earn a lot of money, a larger emergency fund may sustain you longer.
What happens if your emergency fund is too big?
There’s nothing wrong with saving money, and it’s typically better to save money than not. But if you put away more than you reasonably need, you might miss out on ways to build wealth. Here are a few scenarios that could occur.
Your money won’t grow
An emergency fund is a simple way to make sure your money is protected and easily accessible if you need it. But it also means your money isn’t growing because most traditional savings accounts offer low interest rates. And if you factor in inflation, or the general increased cost of goods and services over time, your savings might be worth less each year.
To help combat inflation, it might make sense to put your money in a savings account that earns higher than average interest rates. Read reviews of the best banks and look for savings options with higher rates, including high-yield savings accounts and money market accounts.
You’ll have less to invest
Having more money than you need in your emergency fund can also lead to missed investment opportunities. However, you should keep in mind that investing your money is inherently risky, from investing in the stock market to investing in cryptocurrency. You can explore ways to invest that could potentially grow your money depending on your risk tolerance in our how to invest money guide.
You might miss out on tax savings
Rather than putting more money than you need toward emergency savings, you could invest that money in tax-advantaged retirement accounts, such as a 401(k) or Roth IRA. Both types of accounts could help you save money on taxes, build wealth over time, and save for retirement. As a result, they can offer more potential advantages to putting money in a savings account.
You can’t pay down debt
If you add too much to your emergency savings, you might miss an opportunity to pay down your debt, whether it’s credit card debt or something else. It’s typically better to pay off debt as quickly as possible to avoid paying more in interest.
How to build your emergency fund
Calculate your needs
Track everything you spend for a month or two and figure out which expenses are necessary. Then track your total income amount and set aside a little extra money for unexpected expenses. That will show you how much you need to cover your basic living expenses.
Now that you know exactly how much money you make and how much money you spend each month, cut down on unnecessary expenses. This might look like eating out less each week, canceling a few subscriptions, or changing your shopping habits.
Cutting your expenses should free up some room to start putting money into savings and working toward this financial goal. It’s up to you whether you want to save money on a daily, weekly, or monthly basis.
Automate your savings
If you know how much money you can save each day, week, or month, make the savings automatic. Setting up automatic transfers from an existing bank account to a savings account can help ensure you don’t forget to put money away. Research the best savings accounts and find one that works for your needs.
Saving money can take time, so be patient with yourself and stay focused on your end goal of building an emergency fund. Remember to celebrate your wins to stay motivated and check your savings balance every now and then to see how far you’ve progressed. If you have a big emergency, you’ll be glad you started this fund.
How much of an emergency fund is too much?
You typically want at least three to six months’ worth of savings on hand in case of an emergency, such as losing your job. This can help replace your lost income as you search for new employment.
If you have additional money in your emergency savings for unnecessary expenses, such as streaming subscriptions or a gym membership, your emergency fund might be too big.
How big should an emergency fund be?
The recommended emergency fund size depends on your monthly budget. You typically want up to six months’ worth of emergency savings to cover your necessary expenses, such as housing, food, utilities, and insurance. If you spend around $1,500 on necessary expenses per month, keeping at least $9,000 in your emergency fund will keep you going for six months.
Is $20,000 too much for an emergency fund?
Not necessarily, though it depends on your financial situation. It’s often recommended that you have sufficient emergency savings to completely cover your necessary expenses during a six-month time period. If your typical monthly expenses are around $3,300, $20,000 in emergency savings will cover you for six months. If your monthly expenses are far less, $20,000 might be too much.
There’s nothing wrong with saving up an emergency money fund. In fact, it’s highly encouraged and a frequently recommended personal finance goal. But at a certain point, a large emergency fund might be more than big enough. And continuing to add funds to it could mean you miss out on other financial opportunities.
If you’ve looked over your budget and done the math, you likely know when it’s time to start putting your extra money to better use. This is an important step to take when learning how to manage your money.
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