Last week, I kicked off a 4 part series on building an emergency fund. In part 1, I explained the reasons why everyone needs to set aside money for unforeseen events instead of relying on a credit card as a safety net. Then in part 2, I laid out exactly where you should keep the money you save for emergencies.
But what if it’s not enough?
When the emergency comes, will your planning pay off, or will you run out of reserves and end up covering the rest of the unexpected expense with a credit card or payday loan? To help answer that question, I present you with part 3 of the series:
How Much Money do I Need in my Emergency Fund?
The general consensus is that you should save enough money to cover 3 to 6 months of your family’s expenses, but this number depends on a plethora of factors.Saving enough to continue your normal lifestyle for half a year can be a daunting task, so I think it’s important to break this goal into a pair of objectives.
First, focus on saving enough to cover an unforeseen expense (i.e. a medical bill, surprise trip, or vehicle problem). A good way to do this would be to set aside a specified amount from each paycheck – something that is feasible but challenges you at the same time. For example, add $100 from each paycheck to your emergency fund, which would come out to $2,400 by the end of the first year, assuming you get paid twice a month. Continue this process until you have saved $2,000 plus an extra $1,000 for each other member of your immediate family. Following this plan, a married couple with 2 kids should focus on building a $5,000 emergency fund.
Next, move on to saving enough to cover 3 to 6 months of your family’s expenses in case you lose your job. Determining where you fall within this range is based on 4 factors:
- Are you a 1 or 2 income family? If you and your spouse both work, then the risk of losing all of your income at once is relatively low. In a dual income household, the second paycheck provides a buffer that buys time during the search for a new job. But, if only one member of your family works, or if you work together, such as owning a family business, then the risk of losing your revenue stream is much greater, and you should consider leaning more towards the 6 month plan
- How stable is your source of income? Are you working as a freelancer or for a startup, or are you employed by a well established organization, such as a large company or the federal government? Are you one of the senior employees in a unionized field, or are you the brand new hire who will be the first to go? Make a realistic examination of the likelihood you could receive a pink slip.
- How at risk are you for major expenses? One of the primary concerns here is medical costs. If you or one of your immediate family members is disabled or has battled cancer, then it would be wise to stash away some extra dough in the piggy bank. Some other categories to consider are the conditions of your home and cars. Are you living in a small, new home that should require minimal maintenance for a while, or do you own an older, larger estate that seems to constantly need work? Ask yourself the same question about your family’s vehicles; have they provided consistent reliability, or do they end up in the mechanic’s shop every couple of months?
- How good is your insurance? This is the final point you need to examine, and it goes hand in hand with question 3. If you are surprised by a major medical, home, or vehicle expense, how much could you have to pay out of pocket? Quality insurance greatly reduces the risk of major unexpected bills, so if you own minimal coverage, I recommend increasing the size of your safety net.
Why 3 to 6 months? According to the Bureau of Labor Statistics, the median length of unemployment is 11 weeks. If you save enough for 3 months worth of your cost of living, you should be covered for long enough to find new employment. Considering a combination of the risk of losing your source of income and the likelihood of major expenses while unemployed, you can expand that safety net to up to 6 months based on your family’s needs.
Once you’ve decided the time frame you want to save for, the next step is to determine your cost of living. If you have a budget, this should take no time at all. If you don’t have a budget, you need to make one now; budgeting is one of the personal finance topics I’ll cover in the near future.
As long as you have a budget, add up the monthly allotments for each of your required spending categories. This includes things like gas, rent/mortgage, utilities, and food. For the purpose of this calculation, don’t include entertainment or eating out because you can temporarily suspend both of those categories in the case of unemployment. If you don’t already have a budget, log into your bank account and look at your spending records from the last 3 months. Add up everything except for entertainment and restaurant bills, then divide the result by 3 to find your average required monthly spending. Regardless of which method you used, multiply the result by a number between 3 and 6 months depending on how long you have decided to save for. voila! Now you know how much money you need in your emergency fund.
Now that you’ve found this number, it’s time to put the plan into action and start saving. If you haven’t begun yet, set that initial goal of $2,000 plus 1k for each additional member of your family to cover a major unforeseen expense. If you’ve already done that, start building a safety net to protect your family in case you get laid off. Building an emergency fund is a daunting task, but if you break it into manageable chunks contributed from each paycheck, you’ll start to enjoy the added security of knowing you’re prepared for tough times.
How big do you think an emergency fund should be? Leave a comment below and get a conversation started – I’d love to hear what you think! Also, check back next Monday for the final installation in my 4 part series on emergency funds!