There are different yardsticks out there for creating a credible emergency fund. Dave Ramsey’s recommendation of $1000 is an excellent start if you’ve never had any kind of savings in the past. The only problem with this is that while $1000 is better than nothing, it just doesn’t cover a whole lot of emergency these days. Replacing a car transmission alone will wipe it out (and more) in short order.
Other sources recommend maintaining several months of income, which would be better, but also difficult to accumulate in just a few months. That’s a big key too because emergencies can take place while you’re building your fund.
I think nearly any yardstick is good—the key is to start saving something. But how much that needs to be mostly depends on your own personal circumstances.
Establishing a practical savings target
Here are some guidelines that might help in deciding how much you need to save. Determine which of these are most relevant to your financial situation, then add an amount for each to the fund.
- One month of net income. Most employees are covered by unemployment insurance, but that can take several weeks to kick in under the best of circumstances. A 30 day supply of cash will give you breathing room until the checks start coming.
- An amount equal to your medical insurance deductible. Most plans require you to pay the first $1000 or more of expenses before coverage kicks in; have an amount equal to what ever that is added to your emergency fund.
- An allowance for a MAJOR car repair bill. If you have a late model car, you can probably skip this allowance. But if your car is more than five years old, it might be worth having a couple of thousand dollars added to cover the worst of knock-out punch type car repairs—the kind that rise to the status of emergencies. Providing for this contingency can remove the necessity to replace your car before you’re ready.
- A miscellaneous add-on. Nothing scientific here—this is just my thought based on real life experience. Somehow when we’re hit with a true emergency, and we find ourselves off balance, we get blind sided with extra expenses. They aren’t emergencies in and of themselves, but they can become serious when added to the real thing.
Using the above, you might set a target of $7500–$3000 to cover one month of net income, $2000 to cover your medical deductible, $2000 for a nuclear car disaster and a $500 add-on. Chances are that you won’t be hit with a job loss, a medical emergency and a car disaster at the same time, and because of that, your emergency fund will never be completely drained.
What constitutes an “emergency”?
Once you set a savings target, the next critical step is defining the circumstances under which you might tap the fund—in other words, what will you consider to be a bona fide emergency? Failure to do this might cause you to use the fund to cover ordinary spending problems, like a shortfall in your monthly budget, Christmas spending or even a vacation.
A true emergency should be an event that’s possible, but not probable—something that’s beyond the scope of a normal budget. Some examples might include medical emergencies, a job loss, or a car completely crapping out—as opposed to an expected major repair. Anything that can reasonably be classified as routine can and should be budgeted for separately.
What might be beneficial here is to set up two separate accounts, one as a true emergency fund that isn’t accessed short of an unexpected disaster, and another that you use to cover predictable budget shortages. Regular funding of both accounts will be necessary since all expenses—whether routine or completely unexpected—will only increase with time.
On the road to a cash basis lifestyle
There might be a sense that building an emergency fund is kind of like taking money away from useful purposes and salting it away where it may never be used at all. After all, what good is money if you can’t spend it, right?
But having money just sitting in a bank account doing nothing but backing you up just in case has benefits that go way beyond the obvious.
Stress reduction. Financial stress isn’t usually caused by long term financial concerns, like career or retirement. We have time to plan for those. It’s far more likely to come because either we have expenses we can’t meet, or because we fear we will. By having an emergency fund safely invested, we effectively insulate ourselves from short term financial disruptions, and when we do, we eliminate an enormous amount of stress.
A mind that isn’t burdened by stress is much more capable of dealing with longer term concerns, paving the way for you to build a stronger future. A few thousand dollars in the bank can bring about that freedom.
A platform to launch a debt payoff plan. In recent decades people have often used debt—credit cards especially—as a substitute for savings. No need to have a savings account when you can access a low interest credit card, right?
But until that bogus connection between savings and credit is fixed, the chances of getting out of debt permanently can be low. While you’re paying off old debts, new ones will always arise.
The first step in getting out of debt is to learn to live without it. By having a savings cushion, you won’t have the need to use credit cards to pay for what your income won’t cover. Then, when you pay off a debt, it will truly be gone forever. Having a cash cushion set up before attacking the debt is a strong foundation that can keep you on the road to financial freedom even in those moments when your budget looks impossibly stretched. The psychological benefits alone may be enough to get you past difficult moments without ever actually touching your savings.
The cash basis lifestyle. Once you have enough money saved to get you through short term emergencies, and you’ve begun to methodically payoff any debts you have, you’ll be in a position to live cash-and-carry. No more debt strings attached to your purchases, no more sleepless nights worrying about how you’ll pay the bills next month for what you bought this month. No more bills for yesterday’s extravagances showing up in your mailbox everyday. The light at the end of the financial tunnel begins to become visible.
And it all starts with a well funded emergency fund.
Can you think of other ways to decide how much money we should have in an emergency fund? Can you think of ways to fund it quickly?
(photo credit: mwiththeat)
This post is from FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.