According to the Bureau of Labor Statistics’ May data there are more than a million workers who are unemployed for more than 27 weeks. Emergency room visits are on the rise. Do you have the money to float you on a rainy day? Even if your job and health are perfectly fine, a small car breakdown, a surprise tax bill or broken water pipe might wreak havoc on your financial house. An emergency in itself is stressful, we should not have to worry about how to pay for it or make decisions based on how to pay for it. Even worse, go into credit card debt to pay for it and compound the problem. Almost all personal finance books recommend starting an emergency fund first, whether you are paying down debt or saving for retirement. You see this advice again and again. It is boring advice, but unless you are too big to fail, the only solution to protect yourself from a financial storm is for you to create a rainy day fund!
What is an emergency fund?
An emergency fund is a safety net for financial security. Money set aside in a readily accessible account to cover emergencies such as job loss, illness or unexpected major expenses. This reserve is to be used only for emergencies. No, buying an iPad is not an emergency!
How much do I need?
Some financial experts say you should keep at least 3-6 months worth of minimum living expenses. Some recommend saving a year’s worth of income. There is no hard and fast rule on how much you need to have, I would say decide based on what you feel comfortable with. How much would you prefer to have, to not have nightmares about what will happen if you lose your job?
These are some general guidelines to start thinking about –
- If you are paying a high interest debt, a personal loan or credit card debt, have at least $1000 baby emergency fund to not take on new debt while you are knocking the old one off.
- If you don’t have any debt and have a very stable job; or you are part of a two income family; or you have skills that are in demand and you are confident that you can quickly land a job within a few weeks, then you should stash away the equivalent of a couple of months to 6 months worth of expenses, based on your comfort level.
- If you are the sole bread winner or if you are starting a new business or if you think jobs are not easy to come by in your field or you work as a contractor or on commission, it might be useful to have 8 months – 1year’s worth of expenses saved.
You can adjust the number of months of expenses you need to save based on your comfort level and other available assets/income.
Monthly expenses: If you already have a budget and know where your money goes, you can easily come up with a minimum amount that you will need to have in order to stay afloat in an emergency. If not, consider these –
- Rent/mortgage per month
- Any other fixed payments – car payments, student loans
- Utilities – Power, gas, sewer, water, trash, phone (you could cancel or downgrade your phone if you have a landline or access to another phone, if not you will need it for your job search so count that in), internet
- Regular monthly expenses – grocery, gas, insurance premiums (if you have two cars, consider not using one and ask the insurance company to put it on hold), prescription cost, school tuition, any taxes, association dues that are necessary
- Finally, if you can make do without something, cut it off.
Note: Add in a little for job hunting expenses. My phone bill skyrocketed when I was looking for a job.
Now add everything. That would be the monthly expense you are targeting.
If you want to be protected from Murphy’s Law, consider adding these to your emergency fund –
- If you don’t have a Flexible Spending Account (FSA) or Health Savings Account (HSA) and have money saved up for co-pays and deductible, add in your emergency room co-pay and a couple of doctor visit co-pays.
- Deductible for your car insurance.
Number of months: For this one you really need to assess your personal situation and come up with a number that will make you feel safe. Ask yourself these questions and decide what timeframe you are comfortable with –
- What are the chances I will lose my current job? (Be honest and practical)
- How is my industry doing in general?
- If I do lose my job how long (realistically) will it take for me to get another job that pays at least the same?
- Do I need to go back to school or improve my skills before I can find another job?
- What if I have to take a pay cut or reduction in hours?
- How will I pay the bills if I lose my job?
- How many people depend on my income?
- Can I get a part time job?
- Do I have other sources of income or savings that I can tap into?
- What are the unemployment benefits?
Where should I keep my emergency fund?
By the very nature of this fund, it needs to be liquid. That means you are limited to very low risk, easily accessible accounts. Traditional options to keep the money include –
- Checking account (easily accessible but no return)
- Savings account (very little return)
- Certificate of deposit (depending on the term, decent return)
- Money Market Account
Personally, I would recommend splitting the fund and keeping
- $100 cash at home
- 1 month or $1000 in a very accessible checking account
- Additional 2 months of expenses in
- Rewards checking (pays up to 5% interest)
- Online/High Yield Savings
- Rest of the money (3 months – 1 year) in
- CD Ladder
- Treasury Securities
If you have too much money in a liquid account you might be missing out on make it work for you in a higher risk investment vehicle. So revisit your emergency fund calculation and adjust it according to your current situation. You may want to move some money from it if for example your spouse starts working or you have other assets or you started a business, while you continue to work, and that is bringing in a steady stream of income. You may want to up your reserve if you get married or have a child.
But whatever your situation is, for your own peace of mind, keep at least 3 months – 6 months of expenses saved.