Many people live paycheck to paycheck and have no money in a savings account to fall back on. And that, frankly, is far from an optimal way to live.
If you don’t have some cash reserves in the form of an emergency fund, you might instantly land in debt when an unexpected bill arrives. Similarly, if you were to lose your job, you’d likely end up with costly debt in the absence of savings.
That’s why it’s important to have an emergency fund with enough cash to cover anywhere from three months to a year’s worth of essential expenses. That’s a pretty big range, and you’ll need to assess your personal circumstances to decide which end to aim for.
If you’re single with minimal expenses, you may be okay with a three-month emergency fund. If you’re a single parent with a mortgage and three kids, you may want to aim for a 12-month emergency fund, as that could give you the protection and peace of mind you need.
Meanwhile, a recent CNBC survey asked respondents how much liquid savings they feel they need to be financially comfortable. And for 27%, the answer was $100,000 to $249,000. But for many people, that’s going overboard.
You don’t want to keep too much money in cash
You might think it’s a good thing to load your savings account with extra money. But let’s say you’re aiming for a six-month emergency fund and you spend $5,000 a month on essentials. That means you need $30,000 in the bank.
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Now granted, you might spend more than $5,000 a month if you live in a high-cost area. The point, however, is that the typical consumer generally does not need a $100,000 to $249,000 emergency fund. And if you keep that much money in the bank, you might lose out financially.
Right now, it happens to be that savings accounts are paying generously — upward of 4% in many cases. But there was a time not so long ago when you’d be lucky if you even got 1% back on your money.
By contrast, over the past 50 years, the stock market has delivered an average annual 10% return, as measured by the S&P 500. So even with savings accounts paying so generously, you might still lose out financially by keeping too much money in cash.
Let’s say you really only need a $30,000 emergency fund, but you maintain a $100,000 balance instead. That’s an extra $70,000 in cash.
Let’s also go with today’s savings account rates and assume you’ll earn 4% on that $70,000 over the next 10 years. If so, you’ll be looking at around $104,000. But if you put that money into the stock market and score a 10% annual return instead, in a decade’s time, you could be looking at almost $182,000. That’s a $78,000 difference!
Don’t overfund your emergency savings
You may be inclined to take the attitude that it’s better to have more savings than less. And that’s spot-on. It’s far better to err on the side of overfunding your emergency savings than to not have enough cash to bail you out of a jam.
But unless you’re an ultra-high earner with large monthly expenses, you probably don’t need $100,000 to $249,000 in savings. A smaller balance could still provide the comfort and protection you need without forcing you to forgo more lucrative returns.
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