No matter how much solid financial planning we put in, life cannot be reduced down to complete predictability. Indeed, there are always unexpected expenses, large and small, that can crop up. And, you never know when something catastrophic, like a major illness or a job loss, will happen. The reality of unexpected financial situations should be enough to help you realize that you need an emergency fund. Indeed, many people found this out the hard way when the financial crisis triggered the Great Recession.
An emergency fund will help you prepare for life’s unpleasant financial surprises. Depending on the size of your emergency fund, you can supplement your income if something happens to the ability of someone in your household to work. Additionally, an emergency fund can help you pay for car repairs, or help you take care of other issues that might crop up. A large enough emergency fund can serve as a safety. While it may not provide complete protection, and emergency fund can provide some relief, and help you avoid financial ruin.
Many people wonder how much they should have in emergency savings. The answer, of course, depends on your personal situation, and how concerned you are for the future. An old rule of thumb suggested that you save three to six months of expenses up in order to protect yourself. The feeling was that you could live on the money for a few months while looking for a job, and that such a sum could also easily cover emergency repairs.
However, now some are saying that six to nine months of expenses — or even 12 months of expenses — is a better option. After the latest recession, it has become apparent that some jobs may not be replaced in only three months. What you decide is up to you.
To figure out how much you want to set aside in your emergency fund, add up your monthly expenses. Make sure you include your housing and utility payments, and your debt payments. Use your past two or three months’ expenses as a guide for estimating what you spend on groceries. Bank statements and personal finance software can help you estimate your monthly expenses (e.g., try Personal Capital). Then, multiply that number by how many months you want in your emergency fund. If your expenses are $4,500 a month, you would need $27,000.
Of course, saving up so much money can be intimidating. However, you do not have to have all the money for your emergency fund at once. You can start small. Open a high yield savings account with as much money as you can spare for the savings effort. Then go through your expenses and decide how much you can set aside each month until your emergency fund goals are met. Even if you do not have the full amount of money at once, some savings are better than none, and you can work up to your goal. You can use automated savings to help with your goal.
Remember that your emergency fund should be relatively liquid and accessible. While you could get higher returns in other products, the fact remains that high yield savings accounts are easier to tap than an investment account when an emergency looms.
Eventually, you will have to dip into your emergency fund. When this happens, it is important that you do so in a manner that is planned. First, make sure that you really are in an emergency situation. Wanting a new TV, or getting a down payment for a superfluous car, do not qualify as “emergencies.” Set up separate savings accounts for these short term goals. If you can pay for something without tapping into your emergency savings, do so.
As you use your emergency money, look for ways to stretch your income further. Get a temporary or a part-time job while you look to replace your full-time job, or have your partner work, so that your emergency fund isn’t your only source of income. Look at your spending and see where you can cut back so that your emergency fund lasts longer.
Finally, remember to replace money you take from your emergency fund. You will have to build your fund back up after depleting it a little bit. However, you will be glad you did: You want that money available for the next emergency.