There Is Such a Thing as Too Much Emergency Savings. Here's When You've Reached That Point
KEY POINTS
- You may want to build enough emergency savings to pay up to a year's worth of expenses.
- Money beyond that is cash you're better off investing for a higher return.
A recent SecureSave survey discovered that a whopping 67% of Americans do not have enough cash in the bank to cover a $400 emergency expense. So if you have a large emergency fund with many thousands of dollars, you're clearly in far better shape.
But there may come a point when your emergency savings are overfunded. Here's how to know when you've gotten there -- and why it's a problem.
A year's worth of expenses will generally suffice
There are different guidelines as to what constitutes a solid emergency fund. Some financial experts will tell you that three to six months' worth of living expenses in savings will suffice. Others might tell you to aim for more like nine to 12 months' worth.
But for the most part, once you have enough cash reserves in savings to cover a full year of essential bills, you're pretty set. This isn't to say there's never a reason to save beyond a year's worth of bills. But for the typical U.S. household, a full year's worth of bills in savings offers a lot of protection, and there's really no need to have emergency savings beyond that. In fact, if you sock away more than 12 months' worth of living costs in the bank, you might lose out financially in the long run.
Don't sell yourself short
It's natural to want financial protection, especially if you're the sole breadwinner in your household or if you have multiple dependents who rely on you. But if you keep too much cash in emergency savings, you might lose out on the opportunity to generate higher returns by investing your excess money.
Over the past 50 years, the stock market has rewarded investors with an average annual 10% return before inflation, as measured by the performance of the S&P 500 index. These days, it's possible to find a high-yield savings account paying somewhere in the vicinity of 4%. But that's a lot lower than 10%. And today's higher returns also aren't guaranteed to stick around.
But let's say you have enough money in your emergency fund to cover a year's worth of bills plus $5,000 beyond that. If you were to score a 4% return on that money over the next 10 years, you'd grow your $5,000 into about $7,400. On the other hand, if you were to invest that money in stocks or an S&P 500 ETF, thereby generating an average yearly 10% return, in a decade from now, your $5,000 would be worth around $13,000.
And that's why there actually is such a thing as having too much money in emergency savings. It's good to have a solid cushion in case your job is yanked away or you end up with very expensive home repairs. But once you've reached the point of being able to cover a full year of bills, you can give yourself a pat on the back for a job well done and start investing your additional cash to grow it nicely.
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