If you have a disruption in your income due to a job layoff or even a cut in hours, it’s vital to have a liquid emergency fund to pay for unforeseen expenses like a sudden car or home repair or a medical emergency.
“Everyone needs an emergency fund and the ultimate destination for most households is to have enough to cover six months’ worth of expenses,” said Greg McBride, chief financial analyst with Bankrate. He added that sole breadwinners, the self-employed or those with highly variable income may need nine to 12 months of expenses in emergency savings.
THE PROS AND CONS OF LIQUIDITY
Furthermore, the number of liquid assets you decide to keep on hand will depend on your short- and long-term goals.
“If you are planning for a big life moment, like a wedding or purchasing your first home, you will likely need more liquid assets readily available than someone who is not,” says Leanna Devinney, vice president and branch leader at Fidelity Investments.
LIQUIDITY EXPLAINED: WHAT TO KNOW
Devinney concurs that everyone should set aside three to six months’ worth of living expenses in an emergency fund for life’s unexpected moments.
“At Fidelity, we suggest using the 50/15/5 budgeting guideline to help prioritize spending and savings and start to create a plan: 50% of your after-tax income should go toward essential expenses (rent, utilities, groceries, etc.), save at least 15% of pretax income toward retirement, and 5% should go toward that emergency fund,” she explained.
Devinney reports that most tend to put this money into a money market or savings account, as they are typically more flexible and easier to access than other types of assets.
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How does a household create a formula for this plan?
The best way to plan ahead is to examine your spending habits.
“We recommend reviewing your monthly budget over the last three years,” said Kurt Spieler, chief investment officer of wealth management at First National Bank of Omaha. “After determining whether this budget should be adjusted up or down, the household multiplies the average monthly expenses by the number of months they are comfortable holding cash.”
Spieler suggested households should keep between six and 12 months of their budget in liquid assets.
“For this purpose, we would use bank accounts and money market funds,” he said. “The range of six to 12 months is based on how risk-averse the family is and their comfort level with less or more safe assets.”