In my earlier post about building your cash reserves, I talked a lot about why it was a good idea to have cash reserves and gave a couple of tips for building up those cash reserves.
Today I’d like to talk a little bit about how you can arrive at a number that represents a healthy emergency fund for you in your specific situation. I’ll walk you through my thought process about how I arrived at my emergency fund number.
Let’s start by defining the term “emergency fund”. It’s pretty simple: it’s a fund that we use in case of emergencies. If I lose my job and can’t buy groceries – that’s an emergency. In that situation, I would use my emergency fund to pay for my groceries and other bills instead of using some other source of financing (credit card, loan, etc.).
Since an emergency fund is intended for use in only a true emergency, when calculating an emergency fund amount I like to only think about the bills that I would have to pay in an emergency.
Here’s a rough breakdown of my emergency bills:
-groceries, gas, other necessities
Why do I include those items in my emergency fund calculation? Well, the mortgage and utilities are fairly obvious. I want to keep my house and I want to turn the lights on and have heat. It would have to be a truly dire emergency for me to not pay the electric bill. Groceries are another obvious one – no matter what happens, you still need to eat. Gas and other necessities could be debatable. I like to count these items because even in an emergency situation, I’m going to need to drive places and I’m going to need to do other normal things. Additionally, by including items that could be considered frivolous in an emergency, I am effectively building in an extra layer of reserve. If I had to, I could cut back on something in an emergency and stretch my money even further.
I include insurance and debts here, as well. Many people might not, and that’s ok. My thinking is that insurance is not something you ever really want to be without if you can help it at all. The same logic goes for paying down debts. If you can help it at all, don’t ever get behind on a debt. With that in mind, I like to include those numbers when calculating my emergency fund.
Hopefully, you’ve been doing some financial benchmarking and you have a pretty good idea of what you typically pay for each of these items in a typical month. Let’s throw out some generic numbers, just for our example:
Groceries, Gas, Etc.: $600
Total minimum outlay for one month: $2,150
So now that we have our minimum expenses for one month, we can start playing around with different factors in order to arrive at our final emergency fund number. At this point it is important to remember that there is no perfect number that will apply to everyone. I’m going to mention some general guidelines, but they are flexible for different people and different situations.
In my post on building your cash reserves, I mentioned that I think $1,000 is a great starting goal for someone that has no emergency fund. If you are in the situation of having next to zero emergency savings, I definitely recommend setting $1,000 as your initial target.
If you have $1,000 set aside already and are ready for the next level, aim for one month’s worth of expenses. In our example situation, you would be aiming to set aside an additional $1,150 for a total of $2,150.
If you already have one month of expenses set aside, I think that the next reasonable goes is to go for one month of expenses for each person in your household. If you are single, you’re already there. If you are a married couple, then your next goal is to save up one more month’s worth of expenses. If you have a kid, save a month for the little one.
The general guideline for your total emergency fund that I like to live by is that you should really have two months of expenses set aside for each dependent member of your household. In my situation, I am married with no kids right now. That means I need to have four months of expenses put away, according to my guideline. Once you reach this point, you really have some options regarding your extra cash.
I’m a little more conservative and have decided to keep 6 months of expenses stashed aside for emergencies. Now that I have that emergency fund built up though, what do I do with extra cash? That’s a topic for another day.
There are lots of different opinions about the emergency fund. Many people will say that 6 months is way too much money to be holding in cash – that money could be working much harder for me somewhere other than a savings account. I admit – I think the same thing about once a month. The bottom line and most important lesson to take away is that you need to have money set aside strictly for emergencies. This money shouldn’t be touched for anything else. Getting a sufficient emergency fund built up is not an easy task and can take quite some time, but when you do get there it’s totally worth it.