Most financial professionals would tell you that having an emergency fund is one of the first things you should establish when trying to get your finances in order. An emergency could occur as a result of a job loss, disability, or any other event that causes your source of income to be reduced or eliminated.
What may not be so clear is what the amount of the emergency fund should be, and how to go about calculating it. Different factors come into play, depending on your personal situation.
For instance, if there is only one breadwinner in the family, six to twelve month’s worth of expenses would be a safer bet than three month’s worth, since there is only one source of income for the family to rely on. However, if there are two income earners in your family, you could possibly survive with savings that will cover you for around three to six months. If one of you were to lose your job, you’d still be able to rely on the other source of income.
Furthermore, if your job is a more traditionally “stable” one, such as a nurse or IT professional, you may also only need a three-month emergency fund.
But if your job is not as secure or you don’t receive a steady salary, as is the case with a commissioned salesperson, you’d probably need an emergency fund to pay for six to twelve month’s worth of expenses. This would help you stay afloat until you’re able to find work again. And if you have disability insurance, but the payments don’t begin for six months, you would need an emergency fund to support you in the meantime.
So what should you include in your monthly expenses?
Your emergency fund should only include non-discretionary expenses. These are the necessary expenses that include, but are not limited to:
- mortgage or rent payments
- car payments
- utility bills (water, gas, electricity, etc.)
- insurance premiums
Things that should NOT be included are luxury items, such as Starbucks coffee, video games, eating out at restaurants, and other entertainment expenses. In a real emergency, you should just get by with the minimum until you get back on your feet.
So the simple way to calculate the size of your emergency fund is to total up your monthly non-discretionary expenses and multiply that figure by the number of months you decided your fund should cover you for. If your monthly expenses total $4,000 and you want the fund to last for six months, then your fund should have a total of $24,000.
Similarly, if you already have a savings account for emergency purposes, you can calculate how long that fund would cover you if you were to lose your source of income. So if you had $10,000 in your emergency fund and had $5,000 of monthly expenses, you would simply divide the emergency fund amount by the monthly expenses. In this case, your fund would only last for two months. If you wanted your fund to sustain you for six months, then you’d have to add $20,000 more.
Where do you place your emergency funds?
You should have your funds invested in an account that you can access easily. One of the best types are online savings accounts. These are accounts that are linked to your checking account, so that you can transfer the emergency fund money back into them in the case of an emergency. They pay a little bit of interest, and some banks even offer a bonus to open up the account. Furthermore, since they’re often insured by the FDIC, you can feel good that your money is in a safe place.