The Emergency Fund ratio is commonly used by financial planners to provide insight into your financial security situation. The emergency fund ratio is calculated by dividing your cash and cash equivalents by your monthly non-discretionary expenses. For example; If you have $10,000 in cash and $10,000 in gold coins with monthly non-discretionary expenses of $5,000, then you have an emergency fund ratio of 4 ($20,000/5,000 = 4).
Emergency ratio = (cash + cash equivalents) / (monthly non-discretionary expenses)
Why you need an emergency fund
Your emergency fund ratio is a measure of available cash on hand to handle unforeseen financial expenses and acts as a moat around your assets. An emergency fund is self-insurance against financial events that threaten your more valuable assets.
If a financial emergency strikes and you don’t have an emergency fund, then you are more likely to use a high-interest credit card, personal loan, or sell investments to cover the costs.
What’s a good emergency fund ratio?
Ideally, you’ll have an emergency fund ratio of 3-6 or more depending on the size of your family and your financial situation. The emergency fund ratio is based on your monthly non-discretionary cash flows (mandatory expenses).
What’s an average emergency fund?
In 2014, Bankrate surveyed 1,000 U.S. adults and found that only 23% had emergency savings to cover six months of savings and that 26% had no emergency savings at all (source).
Other notable results of the study:
36% of people with a high school education or less said they had no emergency savings, compared with 10% of college grads.
29% of college grads said they felt “more comfortable,” compared with 18% of those with a high school degree or less.
The average cost of an emergency in the U.S.
Financial emergencies aren’t cheap. They typically require lump sums of cash and or to take on additional debt to cover the cost.
Average financial emergency cost breakdown
Pet medical bills - ~$300 (source)
Car accident - ~$750 (source)
Emergency room visit - $1,400 (source)
HVAC replacement - ~$8,000 (source)
Death of a loved one - ~$10,000 (source)
Improving your emergency fund ratio
The only purpose of having liquid cash available is to cover short-term expenses and unforeseen expenses like the loss of a job or a medical emergency. For this reason, you should strive to have a fully-funded emergency fund, but also avoid having too much cash on hand.
You can improve your emergency fund ratio by increasing the amount of cash and cash equivalents in relation to your monthly expenses. If you reduce your debt commitments, then naturally, your emergency fund can be smaller. Less debt = less non-discretionary expenses.
If your emergency fund ratio is too high (think 10+) then you should consider putting that money into investments or paying down debt. It would be prudent to keep an emergency fund ratio of 6 and place the additional 4 points into a Roth IRA. This will allow you to withdraw contributions penalty-free in case emergency expenses exceeds your 6-month emergency fund.
Increase your emergency fund over time
Emergency funds don’t need to be fully funded in a day, but you should work towards increasing it over time until it reaches adequate size. This is done through the basics of budgeting, reducing expenses, spending less than you earn, and saving the rest.
We always have money going into our emergency fund. Even when it’s fully funded. This ensures that it continues to build over time. If the fund gets a little heavy, we can then transfer some of it into a sinking fund like vacations, holidays, home repairs, etc…
Remember, when you tap into your emergency fund, it’s important to repay that money to your emergency fund as soon as you’re able to. This ensures that you have time to build it back up before another financial emergency occurs.
What’s considered a financial emergency?
A financial emergency is an unforeseen financial event that exceeds your income for that given month. Some months we have minor financial emergencies that we are able to cover with our free cash flow as a result of us using the savings ratio formula to plan our budget.
For example, a television breaking IS NOT a financial emergency. Upgrading to an Xbox Series X video game system IS NOT an emergency. A broken air conditioning system in the middle of Summer IS an emergency. Your kid falling off of the trampoline and breaking their arm IS an emergency.
An emergency fund is a critical component of a successful financial independence strategy. Understanding how to use the emergency fund ratio will go a long way in planning for your financially independent future. Your emergency fund acts as a moat around your assets and allows them to continue to grow and compound.