A very common question when providing fee-only financial planning to clients is:
How large should our fully-funded emergency fund be?
First Things First
Why should you even have an emergency fund? Because “life happens”.
There are times that unexpected expenses occur that need to be dealt with. Since they are unexpected, you don’t have them in your budget – but they still need to be paid.
Rather than getting behind on payments, or borrowing money to make the payments, having cash sitting in an account for just this type of situation allows you to easily pay the expense and continue with your normal household finances.
This is a type of self-funded insurance against unexpected costs that might otherwise throw you off-track.
But how much of an emergency fund should you have?
Like many things in financial planning, there isn’t always a quick-and-easy answer to this. When developing your personal financial plan you need to analyze your (very personal) specific situation.
In general, how big should an emergency fund be?
Financial experts agree that a fully-funded emergency fund should be between three and six months of living expenses.
But what does that really mean?
Notice that the suggestion is based on “living expenses” – not “income”. This is often a confusing point for people who are new to the topic.
The reason we recommend basing the number on living expenses is that if you need to use this money – in a true emergency – then you’re mainly worried about covering the basics. In an emergency, you can easily knock-out eating meals out and going to the movies, and those new shoes (deferred of course, not skipped forever). What you do need to care about though are what is often known as the Four Walls.
The Four Walls
The four walls are comprised of:
- Housing expenses. This, of course, includes your rent or mortgage payment, but it also includes utilities, homeowner’s association fees, and anything else required to keep the roof over your head and the lights on.
- Food. Yeah, you’re going to need to eat. So whatever you need to spend each month to feed your household needs to be considered for sure. You might be able to cut back on a few things in a true emergency but unless you are buying premiums brands of everything, trying to figure out a lower amount here based on being thrifty isn’t worth the effort. Just calculate your normal grocery budget amount.
- Transportation. If you have a car payment, you need to cover that. You also need to include fuel costs and a reasonable amount for ongoing maintenance that may be required. In an emergency, you don’t want to get into a situation where a minor repair throws off your plan and makes a challenging situation even worse.
- Clothing. This is a bit more flexible of a category, especially for adults. But for households with kids who seem to outgrow their clothes on a weekly basis, you definitely need to consider this. There are a lot of things that can be deferred while you are in the middle of an emergency, but sometimes there are also things that are needed sooner rather than later. So make sure this fourth wall is considered.
Now if you want to include other categories you most certainly can do that. In fact, over-estimating can sometimes be a good thing. I like to over-estimate things to avoid surprises down the road. But if your cash-flow is tight right now, or reaching a fully-funded emergency fund is a challenge for you, just include those basics. With those four walls covered you can survive for a certain period of time while you deal with the emergency.
How do you figure out these amounts?
You know it’s coming if you read any of our posts: You need to budget.
When you are telling your money where to go, you can easily just refer to the household budget and take note of the amounts linked to each of these categories mentioned above.
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Three or Six Months?
After you know what it takes for you to cover your living expenses for a month, you need to decide how large the emergency fund should be.
When doing financial planning, most financial experts use this rule:
Make the fund closer to three (3) months of living expenses if: The household has two salaried earners with stable jobs.
Make the fund closer to six (6) months of living expenses if the household has just one salaried earner or if all of the household income is variable – like self-employed or largely commission-based income.
Of course, that just helps set basic parameters. As mentioned above, financial planning is very personal, so you need to take a bit of time to ponder your personal situation. Even if you have a salaried income source, how stable is it? Do you feel that the position is fairly secure? How about a family? Is there a baby planned, because they do tend to cause unexpected expenses to pop up. What about medical and health statuses? If someone is in poor health and sometimes needs medical attention this needs to be considered. With these life circumstances or a variety of others, you should consider going bigger on the emergency fund – certainly toward the six-month range and in some cases even beyond that.
Store your emergency fund in a safe (won’t lose value) and liquid (can quickly access the money as needed) account. The most recommended – for good reason – is a bank saving or money market account. The interest rates will be horrible (at least they are in 2020) but don’t think of the emergency fund as money “invested”. Instead, think of it as money set aside as “insurance”. It isn’t directly used to help create wealth; but it does help because it allows you to keep on your wealth-building plan, and also to avoid taking on debt, in the event of an emergency.
If you don’t have an emergency fund starter at all, first consider a starter emergency fund of just $1,000. Gather this as quickly as you can so you have some level of buffer between you and unexpected expenses. Then you can build from there as appropriate for your overall personal financial plan.
Having a fully-funded emergency fund will help you sleep better at night. Trust me, it really does.
The emergency fund is just one step in developing a complete financial plan for you and your family – it is an essential early step though. If you would like to speak with a fee-only financial advisor about helping to educate and guide you through improving your financial fitness, and working toward the stress-free life of your dreams, you can Start Here to speak with me to learn how we can help you through this process.