How Much Do I Need in an Emergency Fund?
We go into step 3 of our 10 steps to financial freedom. We talk about building an emergency fund to bring you financial stability.
Listen to the podcast and submit YOUR money question on the contact page.
Step 3 is Build Your Emergency Fund
An emergency fund is cash you have set aside to deal with any sudden and severe expenses.
In financial terms, sudden is an event that was not planned. Severe is an event that can ruin your financial health.
Some examples of sudden and severe events:
Job Loss
Home repair
Car repairs
Emergency medical care
What happens if you don’t have an emergency fund?
Without an emergency fund, you will be putting your financial health at risk. There are three main options.
Delay - First option is not taking care of the problem. Car repair comes to mind for this one. One day your car starts having a problem and the mechanic quotes you a large number to get it fixed. Instead of getting it fixed, you decide to continue driving it, knowing that this will only make the problem worse.
Finance - Next option is to go into debt. Debt options available to you would most likely be high interest debt (credit cards). For example, you may have had an emergency room visit and paid this with credit cards. You will then be going back to step two to pay off your high interest debt.
Use other savings - This is for someone that has skipped building an emergency fund in order to save for other goals. In this case, this person could have plenty of difficulties funding this expense. Depending on their saving method, they could have additional taxes or penalties, liquidity issues, and/or investment losses.
So how much should I have?
Everyone’s number will be different, but the framework will be the same. Here are the four factors that add up to your emergency fund goal:
Your income stability
Home value
Number of cars
Number of people in your household
Income Stability - This will likely be the largest factor. The emergency event we are preparing for is a decrease in income. A common example is a job loss, but another example would be having varying income, like someone with irregular paychecks.
So now you have to ask yourself do I have a stable job with a consistent paycheck or am I on the other end of the spectrum. The same question should be posed to anyone else that has an income for the household. You may also find that you may be somewhere in the middle and that is fine. You can split the difference between the savings targets.
Single Variable - 12 months of living expenses
Single Stable - 6 months of living exenses
Double Stable - 3 months of living expenses
Double Mixed - 9 months of living exp
Double Unstable - 12 months of living expenses
Home Value - You want to have some money set aside for any repairs. 1-4% of your home value is the general amount that is spent on home repairs each year. If you are handy, that amount could be lower, and if your house has a lot of problems, it could be more.
Number of Cars - Cars are large machines and will have issues over time. The average is about $1,000 a year in car repairs per year. If you have two vehicles with regular use, you will want to have money available for that.
Number of People in your Household - More people mean more potential emergencies. You most likely have some sort of insurance, so you will want to look into that. A typical out of pocket emergency room cost is almost $3,000. See what your plan covers. Having $3000 per person or your deductible whatever is lower, should be the goal.
Can you be a bit more straight forward?
Emergency fund = 3-12 months living expenses + 1-4% of your home value + $1,000 per car owned + $3,000 per person in your household or your deductible whatever is lower
Here is an example.
Two working adults with two school age children. One of them is a teacher (stable income) and the other is a self-employed handyman (unstable) and rent a house in Dallas, Texas. Both of them own a car, have monthly living expenses of $6,400, and a deductible of $5,000.
$57,600 + no home + $2,000 + $5,000 = $64,600
Some considerations to lower your emergency fund.
Insurance is used to take part of the impact from sudden and severe events. There are a few insurances we will highlight here.
Unemployment insurance can lower the amount you need to cover living expenses. In the example, this family could potentially qualify for $600 a month for 6 months.
Disability insurance can also help cover the cost of being off the job while you recover from an injury.
Home insurance and warranties can lower the costs of major repairs.
Car insurance and warranties can lower the cost of repairs.
Finding health insurance coverage that fits your family also impacts what is required of your emergency fund.
Should I invest my emergency fund?
Your emergency fund should be put into a money market mutual fund or high yield savings account. You want to know you can access these funds at any time without worrying about market volatility.