the emergency fund is a priority
the "rule of thumb" is a starting place - Not an end to the conversation
- Number of dependents (or potential dependents!) -- larger families have relatively more exposure to unexpected costs mounting up quickly and at the same time. For one example, a family with three kids has much more risk of surprise medical costs (one kid with a cold can quickly lead to three kids with a cold!), than does a household made up of a single person without children.
Add to that a situation where an elderly parent or grandparent is not currently considered part of the household, but would definitely be taken in if there was a surprise need.
- Number of incomes -- one possible use for the "emergency fund" is to cover lost wages during times of short term displacement from work; if a person has to deal with a month or two of being unemployed or is laid off unexpectedly, having that cash buffer can help in the gap. Single income homes carry more risk to disruption and therefore may have a larger need in the emergency fund.
- Insurance deductibles -- this whole discussion is around managing risk and demands on cash, and that naturally raises the topic of insurance. In the scenario above with the three sick kids, the actual provisions of the family's health insurance become important. What are the copay levels? What are the individual and family deductibles and out of pocket maximums? In my planning work, I like to consider the aggregate deductibles across a household's insurance policies as an input to their emergency fund needs; while it may not be reasonable or possible to hold in cash enough for the "worst case" scenario, it is reasonable to plan for a "bad case" scenario where multiple deductibles are in play at the same time.
- Asset maintenance and upkeep -- the more things a household owns, the more potential cost there will be to maintain them. For instance, a very general average for the maintenance of a home each year is ~ 1-2% of the home's value. So a $250,000 house may require, on average, $2500+ in annual upkeep (HVAC service, new roof every 10 - 20 years, paint, plumbing, etc). The same goes for cars, boats, RVs -- that there will be expenses is predictable, but the timing and size of those expenses may be somewhat unpredictable.
- Income and access to credit -- a fresh out of school radiology nurse with no spouse, kids, or mortgage and who makes $75,000 per year and has minimal expenses may be better able to roll with a minor cash disruption; a $500 transmission repair could be a small bump in the budgetary road, and she may prefer to cover that expense out of earnings by just cutting back on some other expenses for a month or two. But for a family living paycheck to paycheck, just managing to feed the kids and pay the rent, $500 could be a devastating amount. This point can get a little fuzzy, but when considering a particular household's emergency fund needs, a person with a relatively large "discretionary spending" budget may need a relatively smaller amount set aside in a true emergency fund.
consider a tiered approach to risk
- Cash -- Cash on hand at the house, in a fireproof box or safe, is probably the most liquid option available. The risks are "opportunity cost" (foregoing any interest or growth, like would be available at the bank or invested) and "loss / theft" if the stored cash is lost, forgotten, stolen in a robbery, burned in a house fire, etc. For most people, keeping a small amount of cash on hand is probably sufficient.
- Checking / savings accounts at the bank -- By far the most common option for a household's emergency funds, bank accounts are considered safe (FDIC insured up to applicable limits), liquid (funds can generally be accessed daily by check, wire, ACH, or withdrawal), and partially address the "opportunity cost" issue by offering some amount of interest on balances over time. Some people may choose to have a separate account for emergencies, or to just treat a core amount of their general account as "off limits for spending". The biggest challenge to these accounts is likely the rather low level of interest rates in the current market. While "loss leader" or "teaser" rates at some banks may top 1% right now, most FDIC insured accounts are going to yield far less than 1%.
In any case, for most households, the bulk of their emergency fund should probably be held at the bank.
- Investment accounts -- Any investment offering a higher potential return than the interest on a checking or savings account is going to come with both less liquidity and the risk of loss. Stocks, bonds, mutual funds, ETFs, insurance products, US Trerasuries, CDs -- the whole spectrum of possible investment options are going to have some exposure to one or both of those challenges. And as with any investment choice, people who cannot bear any risk of loss should not expose themselves to that risk.
With all that said, some households or people will find that they are comfortable with having a significant portion of their emergency fund in cash and at the bank, and putting the balance of that fund "at risk" in the market in a measured way. Taxable brokerage accounts (either individual or held jointly with a spouse), ROTH style IRAs (where contributions may be accessible without tax penalty in some circumstances), "permanent life insurance" policies with loan provisions -- these may all in some way play a role in holding a subset of the assets which could be drawn upon in the event of a larger scale financial need.