A good rule of thumb that I commonly hear is to set up an emergency fund before paying down debt, investing, ect. Usually you hear 3, 6, or 12 months worth of expenses recommended.
I have a few questions to ponder.
1) How much is too much of an emergency savings; over 12 months?
2) If your families monthly expenses are two to three thousand dollars, 12 months worth of expenses is not a small amount of cash to be sitting. Should it all be in a bank's savings account or would laddering CDs be a better set up.
3) If you do have an emergency that severely depletes your emergency fund, should you pause your investments and extra debt payments until you fully rebuilt the fund?
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Here are my $0.02 worth.
I think part of the question is what is your employment and family situation. Is your job stable, is your income consistent and reliable or do you depend on commissions? Do you have a wife or kids and is your wife also employed?
Do you have short and/or long term disability insurance?
I think those questions determine how much of a fund you need. If you have a stable job and few liabilities than 3 months should be fine. If you are in sales and relying on commissions for income and have a stay at home wife with 4 kids, it would probably be better to have more than that.
I wouldn't be concerned too much about earning any income on your emergency fund. The money should be liquid and easily accessible if you have an emergency. The purpose of the fund is safety and insurance, not an investment.
I think if you have an emergency and deplete the fund, you should put investing on hold until the fund is built back up.
Depending on the debt you are talking about paying extra on, I wouldn't be making investments until it is paid off. Mortgage on your personal home or possibly a very low interest student loan is ok, but if you have credit card debt, car loans, etc. then pay those off before beginning any serious investing.
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EricL summarized it well. We use a similar strategy.
My wife has a very stable and secure job. My job, not so much. Both of us have short term and long term disability insurance coverage (and life insurance). Considering all these points, we maintain approximately 3-4 months in emergency fund cash.
In the past, I used to invest that in bond funds, but in the last year, we decided to move it to cash. I still see that cash as dead money not being invested, but take refuge in knowing that the current low inflation environment is not eroding that value rapidly.
crimsonghost747
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I agree with Eric, it's all about your personal situation.
Someone with a steady job with pretty much no chance of getting fired, rental apartment (so if something breaks then it's the landlord, not you, who pays to get it fixed), no car etc. doesn't need to keep more than 2-3 months of emergency savings.
On the other hand, if you have an old car and an old house it's much more likely that you will need that emergency fund quite often. Same thing if you work freelance or in an industry with a not-so-bright future. In these situations I'd say 6+ months is a safer bet, especially as you might run into a situation where you lose your job and then you need to fix the car/house.
Refilling the emergency fund should be the #1 priority if you have emptied it for some reason, though of course be smart about it and don't leave a 10% credid card debt hanging. But emergency fund takes priority over investments and paying back low interest debt.
