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The traditional emergency fund is 3-6 months of expenses. Most people don’t have it and some have way more but the one thing everyone can agree on is that they have no idea what their 3-6 months of expenses should look like.
The first step to having a solid emergency fund is knowing why you need it and what it’s for. If every time you save $1000 you have an “emergency” haircut, you’ll be battling this vicious cycle of emergencies forever.
Why do I need an Emergency fund?
An emergency fund is for unexpected emergencies. You know they’re coming but have no clue in what form or budget category they’ll fall into. You have a fund to keep you out of debt and keep you from going into crisis mode (because people in crisis mode inevitably make poor financial decisions.)
Emergencies include hospital and emergency walk-in visits, anything blows on the car (assuming you need the car), or job loss. You use an emergency fund for anything that would throw you into crisis mode, ie. not a haircut.
How do I figure out my monthly expenses?
You can’t do this without a budget. There’s no law stating what’s an expense and what’s not so you need a written budget, on paper, to see where your money goes and what you value.
To calculate your monthly expenses just add up everything you spend in a month, that’s it. For those of us who might be embarrassed about how much of our monthly expenses say “Starbucks” then stick with the pared down version: All monthly bills + groceries.
Chances are if you lose a job you shouldn’t be buying new clothes and eating out so just enough to cover the bills and feed your family is enough.
If you want a more in-depth analysis of monthly expenses you can use this calculator from Frugal Village to figure it out.
How many months of expenses should be saved?
That’s the big question, isn’t it? Most people can’t keep $400 in savings and others freak out when they dip below $10,000. What’s the magic number?
First, focus on getting to $1,000. That’s the big hurdle for most people and if you can get there then you can start focusing on other financial setbacks (like debt.) I always recommend keeping it in a separate credit union savings account so there are no fees and you don’t have access to it when you’re out and about.
Your emergency fund should be liquid (can be withdrawn quickly) but not easily accessible (in a credit union that’s out of the way and keep the card at home.)
I also recommend being out of debt before building your full emergency fund and here’s why: The interest accruing on debt is more than anything you’re going to make in the best savings account. Tying up these funds loses you money and gives you false security that you have wealth that really isn’t yours.
A creditor with access to your accounts can drain you or if you die your assets go to pay your debt, not to your family. So once you have enough to cover emergency expenses, increase your side income streams, pay off your debt then build your full emergency fund.
Also Read: Is Being Debt Free Worth it?
Deciding to save 3, 4, 5, or 6 months of expenses comes down to how likely you are to lose your income and how quickly you could find a similar paying position if you lost your current one. Professions with high job security like doctors, engineers, and government employees are safe with three as are people that have skills and qualifications that make them easily employable.
If you have a skillset that’s narrow or work in a dying field (like one that’s becoming more automated) then it may be really hard to replace your income. You should go with 6 months, and start looking at side hustles to diversify your income.
Most individuals and couples will fall somewhere in the middle of these. There’s no wrong answer when saving an emergency fund. (Obviously you’re beating most Americans by just seeking out this info.) Balance out the “securities & insecurities” of your financial landscape and decide for yourself.
I’ll use us as an example:
I have a very secure job at a small business and multiple side income streams. My skillset however, is very narrow so I may not be able to find another job if I lost my main gig. My husband has a well-paying job in a volatile industry. He could easily lose his job (and has) depending on the season or new management. His niche is also narrow. I think this puts us in the 5-month category.
If we both lost our jobs we would have enough side income to keep us going until he found a new job and I could ramp up freelancing to fully replace my lost income. So at $2,000 monthly expenses, we plan on having an even $10,000 emergency fund. This might increase when we have a kid but it feels good right now.
Should I save more than 3-6 months expenses?
Some financial advisors suggest 8-12 months of expenses in an emergency fund. It seems like a novel idea to have $20,000 sitting in the bank smiling back at you but is it a good financial move?
Chances are if you have a minor medical emergency you’ll be able to cover it in $10,000 (be sure to practice your negotiating skills in billing!) and if you lose you job and you’re not at least partially reemployed or working for yourself in 6 months then the problem isn’t the emergency fund.
So why am I against the extra savings account padding? For the same reason I think you should pay off your debt before building a full emergency fund, interest. Investing even in low-performing Roth IRAs and mutual funds will yield more compound interest than any savings account.
That $10,000 over 30 years at a conservative 6% growth will net you over $47,000 in profit, and that’s if it were just by itself. If it’s on top of your recurring retirement contributions it gets you even more.
The only reason I would put more away in the emergency fund is if you’re nearing retirement. While another crash like we saw in 2008 is unlikely, if you decide to retire in a down market you can lose a lot of what you’ve built. If you’re 10-15 years from retirement and you want to pad that emergency fund more, I think that’s a great idea.
Moral of the story, it’s important to have an emergency fund. Don’t worry about the amount; focus on the individual steps it takes to get there. If you’re on it with focused intensity you’ll maintain financial health for the long haul and the hope in financial independence is to have enough in your checking and dividends that you don’t even notice your emergency fund.