How Much Should I Save in My Emergency Fund?

| February 10, 2014 | 0 Comments
What is an Emergency Fund?

Everyone interested in creating financial stability in their lives should strive to have a fully funded emergency fund in place.  The main purpose of this fund is to cover your living expenses if you are unemployed.  That's it.  After funding the account, you can essentially forget about the money in it unless you are without an income.  If you are never unemployed, the money was not wasted.  For decades, this cash served as a safety net and reduced the stress that could have been felt when layoff rumors started circling around the office.

How Much Do I Really Need?

Three-six months of income has been the standard one-size-fits all answer for a while, but each person/family should consider the variables that affect their personal situation.  When you are deciding how much you should save, consider how long you think it would take you to find a new job. If you work in retail, you can find a new job easily. If you have a high-income executive position with a specialty in a low demand field, you could have a much harder finding a job in your area for a lot longer. If you work in sales and are used to a large portion of your income coming from commissions, remember that you might have a long ramp-up time when you change jobs and even though you start working quickly, your income might take months to catch-up to what you are used to.  If you own your own business with a strong track record of steady income through recessions or have secure employment as a teacher, doctor, CPA or attorney, the risks of being unemployed are much lower and that means your emergency fund can be smaller too.

When determining what variables affect you, consider what your monthly spending is versus what you take-home each month. If you take-home $8,000 per month, but save $1,000 per month, then you can base your needs on $7,000 per month. You can reduce this amount further by subtracting other variable expenses that you won't incur while unemployed, such as vacations and expensive dinners or material items (i.e. the new iPhone or big-screen TV can wait). You might spend $1,000 per month on "stuff" that isn't really essential. This frivolous spending can be cut easily and your monthly spending can come down to $6,000. You can also expect unemployment wages to help cover some expenses, but this is often less than people expect and a lot of it goes to cover higher insurance costs through COBRA without the employer's subsidy.

Lastly, if you have a working spouse, consider how much each of your income can be used to keep the household running while you are unemployed. Sometimes, you can save on expenses such as childcare while unemployed and you will have more time to cook meals rather than eating out on a regular basis.

In other words, there are a lot of variables, but it comes down to each person's individual needs and situation. You might only need three months of expenses saved, but you could need nine months worth of expenses.  The trick is to start saving and reduced fixed-expenses (such as financed items that you could've waited and paid cash for). Don't forget to review your emergency fund every few years as earnings increase and expenses rise.  Just because you saved six months of expenses when you were 30 years old, it doesn't mean it will cover you when you are 45 and have a couple of kids.

Where Should I Save It?

Separating funds is a great way to avoid borrowing from yourself or thinking you have more than you do.  Although interest rates from savings accounts and CDs are miniscule lately, money that could be needed in the near-term should be kept in one of these accounts.  This is not the growth area of your portfolio and should not be treated as such.  The risks involved with stocks or longer-term bonds are too great for money you might need quickly in a pinch.

This account should be held separately from other accounts, such as checking or investments.  It's important not to mix your vacation or new house funds with your emergency funds because you don't want to be tempted to dip into what should be saved for a true emergency.  The emergency fund is also different than what might be earmarked for regular maintenance on your home.  (You are saving for maintenance costs each year, even if you don't incur the costs that year, aren't you?  You know your [fill in the blank] isn't going to last forever.)  These funds can be mixed, as long as you keep in mind the threshold for what is only to be used if unemployed.  I believe it's OK to mix these two different plans because when funds will be needed for some home maintenance expenses are unknown, outside of knowing they will come one day, such as a new roof.  (Hint: Your home's roof is aging and will have to be replaced eventually.  Don't lie to yourself and believe it'll last longer than average.)  For example, if you've set aside $36,000 to cover your expenses for six months and you grow your account to $40,000, only $4,000 (40k-36k) should be considered allocated for maintenance costs.

Of course, saving an emergency fund is moot if you have credit card debt.  Before socking away money in a low interest savings account, all credit card debt should be eliminated.  After credit card debt is eliminated and an appropriate emergency fund is created, then you can start investing in stocks for some real growth.

This might sound like a lot of work, but if you are living beneath your means, it is surprisingly easy and hopefully you'll never need it, except to help you sleep better.

Filed Under: Spending


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