NEW YORK (BankingMyWay) -- Everyone knows you should have a rainy-day fund to cover six to 12 months of expenses. But which is it -- six or 12? Or more? Or less?
With savings accounts paying next to nothing, an overly large rainy-day fund would mean skimping on other investments that could generate bigger returns. On the other hand, keeping too little could invite disaster in a financial emergency.
While six to 12 months is a good starting point, tailoring a rainy-day fund to your unique circumstances requires a look at several factors.
1. How secure is your income?
A worker with a lot of seniority in a union-protected job will probably have better income security than a salesperson relying on commissions. A person with a college education might well have a more secure job than one who has not finished high school. A retiree who can live on a traditional pension and Social Security is more secure than someone counting on gains in stocks and bonds. A couple living on two incomes is more secure than a couple or individual living on one. The less secure your income is, the more you should put into the rainy-day fund.
2. How predictable are your expenses?
If your family has stopped growing, you have just one home in good condition and drive relatively new cars, your expenses are likely to be pretty predictable, so you’ll know how long your rainy day fund would last if, say, you lost your job. But If you’re living without medical insurance, have a growing family and must constantly plough money into a business, there’s no telling how your expenses could grow. The less predictable your expenses, the bigger your emergency fund needs to be.
3. How easily could you adjust your expenses?
If you spend a lot dining out, keeping up a fashionable wardrobe and traveling, it should be fairly easy to cut back if times got tough. The rainy-day fund need only be large enough to cover necessities and unexpected outlays, like a new roof or furnace. The more you can cut, the smaller your fund needs to be.
4. Do you have a backup for your rainy-day fund?
Your official rainy-day fund might be in easily accessible and stable holdings like bank savings and money markets. If you have sizable holdings in short-term bond funds with stable prices they could provide better returns than your rainy day fund and be tapped easily if the emergency fund fell short. But if your other investments are concentrated in stocks or other holdings that can have big price swings, they do not provide a good backup. You don’t want to have to sell stocks in a downturn just to buy groceries. The more stable and liquid your backup, the less you need in the rainy-day fund.
Keep in mind that the rainy-day fund should not become a tail wagging the dog. Investment accounts should be divided between stocks, bonds and other holdings in the way that best suits long-term needs like retirement and college expenses. Skimping on stocks to boost the rainy-day fund could undermine your long-term gains, leaving you short later on.
If, after weighing all these considerations, you decide your rainy-day fund should be bigger, the best approach is to trim expenses. That will reduce the size of the fund you need and give you spare cash to build it up faster.
More on rainy-day finances:
Rainy-day funds: treasury notes or long-term CDs?