I know you’ve heard it before.
“You simply MUST have an emergency fund.”
You’ve probably also heard a wide range of figures telling you how many months of expenses to set aside.
3 months. 6 months. 12 months.
Gee thanks. Now I still have no idea, right?
Yes. You know you need to have savings.
Yes. You know you need to be prepared for an emergency.
But what is the answer? As with most things in life, determining your target amount for an emergency fund is not black and white. You also cannot predict the future. No matter how hard you try. As a financial planner I spend so much of my time thinking about what could happen, I think clairvoyant abilities would really help my business out. But sadly, I don’t have that ability and neither do you. So how can we make an educated guess since that’s all we can do?
Here is how I make my “educated” guess for my clients and hopefully this will help you too.
An emergency fund should generally be between 3 and 6 months of mandatory expenses. Mandatory expenses will include everything you need to keep the bill collectors away and keep a roof over your head. Add them up:
Housing: mortgage or rent
Debt: car loans, student loans, credit card
Utilities: water, electric, gas, internet, cell phone
And all other expenses that are necessary to live your life (please note I didn’t say best life). This would include groceries, fuel, childcare and more dependent on your unique situation.
These are your mandatory expenses.
Now, in an emergency you won’t be living your best life but you should plan on living your life a little. I know that if I lost my job, I wouldn’t want to be cooped up in the house all day thinking about what went wrong and longing for those days when I could get a latte from Starbucks. That’s why I like to include a bit of discretionary spending in an emergency fund as well.
Discretionary spending is for extras like dining out, new shoes, vacations, the dollar section at Target. These are things you don’t need but you want or are part of your lifestyle. I recommend adding up your average discretionary spending, take 50% of that number, and add it to your mandatory expenses for your monthly emergency total.
Easy enough. So how many months do we need of this monthly emergency total?
Time to do a little more math. It’s easy. I promise. Ask yourself these questions:
Does your household have one earner or two? If one person loses their job, there is still another person contributing income to the household. If you have one earner, give yourself a 6. If you have two earners, give yourself a 3.
Do you have one source or income or more? If you other sources of income besides wages, that will come in handy in an emergency This could include a business, rental income, or investment income. If you have one source, give yourself a 6. If you have multiple sources, give yourself a 3.
Is your household made up of one adult or two? Even if only one individual in the household is currently working, that still means there is another person who could potentially go to work if needed. If you are 100% on your own give yourself a 6. If you have a partner who could help out if needed, give yourself a 3.
How stable is your job? If you work for a start-up or a company that appears to be struggling financially or even an industry that hasn’t kept up with the times we live in(a local newspaper for example), your job might not be on the most solid ground. If you work for a large profitable company or a major public organization (like a school or a hospital) you are probably a little on the safer side when it comes to a potential lay off. Stable job, give yourself a 3. Not so stable job, give yourself a 6.
Do you own a home with equity available? As you pay down your mortgage, you build equity in your home. Once you have certain amount of equity build up you can establish a home equity line of credit. This is a line of credit which enables you to borrow from the equity in your house. In a high interest rate environment, this may not be the best route to help fund emergencies since the cost of interest can be a drain on your resources. However, in a low interest rate environment this may be an option to help fund some living expenses in an emergency. If you have equity in your home, give yourself a 3. If you don’t own a home or have < 20% equity in your home, give yourself a 6.
Add up your totals, divide by 5 and there you have it. An educated guess on how many months of those mandatory and discretionary expenses you should have on hand for the unexpected.
Keep in mind, this money should be kept in a safe highly liquid account.
A traditional savings account is a good option. Another option is a high yield savings account. I typically recommend using a high yield account for two reasons. One, these accounts pay more interest than a traditional savings account. More interest. More money. Two, these accounts are often at a financial institution other than your traditional checking and savings. While the money is still accessible, this keeps it out of sight and out of mind so you aren’t tempted to tap into those funds when you’re a little low on cash and the new iPhone just came out.
Much love and happy saving.