An emergency fund will help keep you in the drivers seat when the unexpected happens.
There are two good reasons to have an emergency fund:
- It is your insurance to protect youurself against a temporary loss or reduction in income.
- It is your insurance when you have an unanticipated expense; such as an expensive car/home repair or medical expenses.
Nearly every one of us needs an emergency fund. But how much do you need? Some experts recommend saving as little as 3 months the equivalent of your living expenses for an emergency fund, while others recommend 12 months. At the start of the recession, as it became more apparent that they recovery in the job market wasn’t going to be a quick and easy ride, more personal finance experts have been leaning towards the 12 month mark.
However, personal finance management is never “one size fits all.” To help determine how much you should have saved for an emergency consider the following factors:
- What line of work are you in and in what location? Some fields are more stable than others in regards to the economy and politics. For example, when a recession hits, a person who works in manufacturing is more vulnerable for losing their job than a nurse would be. Typically, recessions hit manufacturing the hardest; whereas, they may have little to no effect on the need for nurses. Where you live can also have a big influence on your emergency fund needs. If you live in an area, where there are only one or two employers of your line of work, than finding replacement income would be much more challenging than if you lived in a location where there are numerous employers that you would be qualified to work for.
- Do you have a mortgage? If you lose your income the stakes can be much higher if you have a mortgage. You risk losing your home and all of the money that you have invested into it. On the other hand, after the loss of income, it would be easier for a renter to walk away and either find cheaper rent or temporarily live with family or friends.
- What is your current (or foreseeable future) family situation? The emergency fund needs of a single 23 year old will probably be very different than it would be for a 40 year old with a family. The “acceptable options” for a 23 year old may be more flexible. A 23 year old may just have to swallow their pride and move back in with mom and dad or with a friend if things got tough. In the case of a family; uprooting a family may be much more challenging and difficult. Also to keep in mind, some people have family or friends that they can count on in a worst-case scenario, while other people have nobody who can help them.
- How much are you willing/able to “cut back” if your income is reduced? Some people would find it very difficult to modify their lifestyle, such as cutting out the cable or reducing/eliminating their cell phone plans, in the event of a negative change in income. What is your sensitivity to cutting back on expenses. Many people who loose their jobs, don’t cut back on expenses until they have no other choice. If you find “cutting back” very difficult, then you need a larger emergency fund.
- What other income options do you have? If your income is adversely affected, can some of that lost income be made up. Let’s say you have a “traditional family” where dad is the bread winner and mom is caring for the kids and managing the house. If you lost your income, perhaps mom has a degree or skill and can easily go to work to fill in the gap. On the opposite side of the spectrum, you are single where you are the only option for a household income. Or another scenario is where both a husband and wife work for the same company and that company is struggling; in which case there could be a loss of both incomes and the risk is higher.
- What types of assets do you have? So far, the questions I posed dealt more with losing income. But what about unexpected expenses? The assets you have should be a factor in determining your emergency fund needs. If you own a home or rental property then your needs will be higher because of the potential of having to make costly repairs. What other assets do you have that may require expensive and unexpected “upkeep”?
As you can see, determining your emergency fund needs isn’t as easy as just doing simple math. Our emergency fund needs also has a lot to do with our lifestyle as well as our level of risk aversion.
These are just some factors to consider when determining how large of an emergency fund you should strive for. If you have other factors, please share them in the “comments” section!
Also, since building an emergency fund can take months or years to accomplish, it is also important to think forwardly when planning. For example, you may be a 20 year old still living at home; but in that case why not start preparing for when you are 25 with a family of your own?
Here’s a relevant quote from Henry Buckley:
“Save a part of your income and begin now, for the man with a surplus controls his circumstances and the man without a surplus is controlled by his circumstances.”