As a financial planning professional, one of the first questions people ask me when it comes to their personal finances is “what do I need to set aside for emergencies?” The answer to this question, like many other real-life questions, is it depends. While no two individuals and/or family situations are exactly the same, there are some general guidelines that may be helpful to follow when determining the size of your emergency fund.
First, what is an emergency fund? This sounds like a simple question with a simple answer, right? It does have a simple answer, but it is also one that people tend to misinterpret.
- What it IS NOT – Available credit, whether in the form of a credit card, bank line of credit, etc. or a let’s take an unexpected trip to Jamaica fund.
- What it IS – An account that is readily accessible, liquid, preferably interest-bearing and not subject to extreme market risk (not invested in stocks, bonds, etc.) that you view as basically the same as $0.00. These funds should be held and used only for their namesake…EMERGENCIES (job loss, medical emergencies, unexpected home/car repairs, unexpected travel, etc.).
Once someone understands what an emergency fund is, the next question is how much should be in the fund? The general rule of thumb out there that is quoted most often, and that I typically tend to agree with, is 3-6 months of living expenses. What is sometimes harder to figure is the question of “What expenses should I consider living expenses?” and “Should I lean more towards 3 months or 6 months?” The answer to these can obviously drastically affect the size of you targeted emergency fund, so let’s try and establish some general ideas:
When it comes to expenses to consider when determining your target emergency fund amount, I typically try to estimate and include all critical “must pay” expenses while disregarding any expenses that you would be able to cut from your budget in the event of a significant emergency. Some examples in both categories are:
- Expenses to Include – Housing, food, healthcare, utilities, transportation, personal expenses and debt
- Expenses not to Include – Entertainment, restaurants, vacations, savings/investment contributions towards other goals and nonessential shopping
Here are some guidelines as to the number of months your emergency fund should cover:
3 months if:
- Single with a second reliable source of income (alimony, trust income, annuity, etc.)
- Married, both work and generate similar income
- Married, only one spouse works but has a second reliable source of income
- You have multiple sources of income and the loss of any one would be around 50% or less
6 months if:
- Single wage earner
- Married but one spouse earns substantially higher wages than the other
- Married but only one spouse works
One thing to remember is that these are general suggestions. Some situations call for larger or smaller emergency funds. For example, you work in an industry or for a company where layoffs are common or if you’re income isn’t steady (self-employed or commission based). In this situation a larger emergency fund may be more appropriate.
Life is full of surprises, so it is fairly reasonable to expect a financial emergency at some point in your life. However, having an appropriate sized emergency fund for your individual situation will not only provide peace of mind, but it could also prevent you from making a really bad financial decision when the unexpected strikes.
-Jay McGowan-
