Emergency Funds: How much do you need to set aside?
22 July 2006An emergency fund is an amount of money you set aside to cover the unexpected expenses that life seems to throw at us. Your car broke down? Your refrigerator stopped working? The AC shut off in the middle of the summer? If you don’t have an emergency fund, and are living from paycheck to paycheck in your bank account, you’re not going to have the money to pay for these things.
The simple answer most people use is to borrow the emergency expenses on their credit cards - after all, that’s what they’re there for, right? Wrong. If you use your credit cards to pay the cost of an emergency, you’re likely to keep building up debt over time - after all, emergencies tend to keep happening over time, too. Many people who get in over their heads in credit card debt start out this way, and not really as irresponsible spenders.
An emergency fund sets aside money that you do not allow yourself to touch unless you absolutely have to. If you do touch it, you commit yourself to paying it back until it hits the set amount you want in the fund. It’s often better to put this money into a separate bank account so that you don’t accidentally spend it, preferably one that earns interest - but make sure it’s money that you can still get at immediately if you need to.
How much should I keep in my emergency fund?
Ideally, your goal should be six months worth of EXPENSES. That doesn’t mean your salary - it means that if the biggest emergency of all happens, losing your job, you can still live off the emergency money for six months. To figure out how much you need, you need to do a budget first. Add up all your bills for the month, and keep in mind the amounts you spend on the little stuff - eating out, food, entertainment, etc. Multiply that number by 6, and you’ve got the amount your emergency fund should be. So if you spend $250 on a car payment, $1000 in rent, $350 in other bills, and $150 on necessary expenses each month, then you spend $1750 a month - and you need $10,500 set aside for emergencies.
This sounds like a lot - and it is. But the reason you need this is that losing your job could otherwise destroy you financially. It can force you to dip into your retirement savings, build up credit card debts you’ll never dig out of, or ruin your credit by not paying the bills. An emergency fund guarantees that most emergencies will pass without you needing to worry too much. Six months is plenty of time for most people to find a new job - and it’s a great cushion for other big emergencies like health problems or the death of a spouse or loved one.
For most people, it will take some time to get there, especially if they don’t have any funds set aside right now. You’ll have to put money into your fund over time. Set aside a certain amount to go into the fund until it gets to your goal. You should also make little goals, not the full six months - start out trying to build your fund up to one month’s expenses. Then shoot for three - and finally for six.
You also need to remember that an emergency fund is not a substitute for retirement savings. It should probably be a bigger priority if you don’t have one - but eventually, you’ll have to start socking away money for retirement separately.
Discuss this and other financial issues in the Free The Drones forums here.
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