Having an emergency fund means you have access to cash so that you can pay your bills in the event of a financial emergency like losing your job.
Most financial experts recommend having between three and six months worth of living expenses in your emergency fund. The truth is that it depends on your personal circumstances. Some people are comfortable with a one-month emergency fund, while for others, it makes sense to have at least one year’s worth of living expenses set aside.
Let’s review all the factors you need to consider when building your emergency fund.
What expenses an emergency fund should, and should not cover
The first step to building an emergency fund is to be crystal clear on what expenses you want your emergency fund to cover.
Many people think that an emergency fund should cover all of your regular spendings. I look at an emergency fund as a way to guarantee I have enough money to cover all of my essential expenses.
Essential expenses I include in my emergency fund
Housing.
Transportation.
Groceries.
Cell phone and internet.
Minimum payments on debt.
Medical bills and expenses.
Child and childcare-related expenses.
Any other expenses I absolutely can’t cut.
The reason I focus on essential expenses in my emergency fund is that if I am experiencing a real financial emergency, I will be forced to cut all non-essential spending until the crisis is over.
Think about it this way; if you lost your job and your emergency fund was your only source of income, would you feel comfortable withdrawing from your emergency fund to take the family out to dinner and a movie?
I know I wouldn’t.
Having lived through true financial emergencies in my life, my emergency fund has an obvious and specific purpose; keep a roof over my head and food on the table for as long as possible.
In certain circumstances, it makes sense to include “non-essential” spending in your emergency fund. For example, if you have kids, would it make sense to add something like the cost of a Netflix subscription in your emergency fund?
It is certainly not “essential,” but if shutting off the Netflix account without warning would cause conflict and stress at a time where you don’t need either of those things, then you might want to include that in your emergency fund.
You need to be honest with yourself and identify which expenses you simply don’t have the stomach to cut. Even if they are not essential, if you won’t actually reduce these expenses, it’s best to plan for that fact and include them in your emergency fund.
Just remember, the more expenses your emergency fund needs to cover, the more money you need to save.
You need to track your spending
Once you establish which expenses to include in your emergency fund, the next step is to figure out how much you spend on these items every month. To do that, you need to track your spending.
That means going through your credit card and bank account statements as well as the receipts for any purchases you’ve made in cash. When tracking spending, I like to break down my spending into one of three categories.
“The big 3” expenses of housing, transportation, and food.
“Values,” which are non-essential spending on things that make you happy.
“Stuff,” which refers to non-essential spending on things that provide no value to your life.
Go back and track multiple months’ worth of expenses so you can get a sense of how much you spend on average on each item you wish to include in your emergency fund.
How many months worth of living expense should I have in my emergency fund?
After tracking several months’ worth of expenses and figuring out how much you spend on average on the expenses you want your emergency fund to cover, the final thing you need to decide is how many months you would like your emergency fund to cover.
The typical advice is to have an emergency fund that can last for three to six months.
However, that number can change significantly depending on two factors.
How secure your income is.
Your personal preference.
If you live in a two-income household with a high level of job security and where either person’s income could cover your necessary living expenses, you probably don’t need a full six-month emergency fund. Unless it simply makes you feel better to have six months’ worth of expenses in an emergency fund.
If having a large emergency fund will let you sleep better at night, then go for it. Personal finance is the art of balancing “the numbers” with your personal preferences. An emergency fund is no different.
On the other hand, if you have very little job security, you may want to consider a larger emergency fund.
Consider someone who is recently retired and gets the majority of their income from their investments. They may want to have one or even two years’ worth of necessary living expenses in their emergency fund.
Should you invest your emergency fund?
Another question that people often ask if it is okay to invest the money in their emergency fund in a risky asset like stocks.
You should never, under any circumstance, risk the money in your emergency fund.
Think about when most people would need to rely on their emergency fund; when they have lost their job.
When do a lot of people lose their job? During a recession.
What happens to the stock market during a recession? It goes down.
If you’ve just lost your job and your emergency fund was reduced by 50% or more at the same time, you will be in a world of financial hurt.
I realize there is nothing fun or sexy about emergency funds, and that is by design. Think of your emergency fund as taking your financial medicine.
How much money should you be saving into your emergency fund each month
Four factors need to be considered.
How much you spend on your essential expenses each month.
How many months worth of expenses you want in your emergency fund.
When you want your emergency fund to be fully funded.
How much you currently have saved in your emergency fund.
Let’s say you track your spending and determine that you spend $2,500 per month on necessary spending. You also decide that you want a six-month emergency fund set up in five months and have $3,000 already saved.
Your total emergency fund would be $15,000.
You need to save an additional $12,000.
To fully fund your emergency fund in five months would mean you need to save $2,400 per month.
Your emergency fund is your number one financial priority
Your emergency fund is the foundation on which the rest of your financial plan will be built.
For that reason, you must have an emergency fund in place.
Many experts recommend three to six months’ worth of living expenses in an emergency fund. Make a list of all the expenses you would not be willing to cut, even in a financial emergency.
Then track several months’ worth of spending to determine how much you spend on these items.
The final decision you need to make is how many months you would like your emergency fund to last, which will be mainly determined by how secure your income is and your personal preferences.
An emergency fund should come before any financial goal with the one exception of making the minimum payments on your debts. That may not be an appealing message if you are heavily in debt or eager to start investing. But an emergency fund is about protecting you from unexpected financial hardships, so it needs to come first.
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This article is for informational purposes; only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any significant financial decision