In a previous article, we talked about knowing your cash flow and how its possible variations might affect you. One way to mitigate the risk of needing a lot more money than usual in one month is to have an emergency fund. This shouldn’t be news – I know of no school of thought in personal finance or life planning that doesn’t tell you that you need an emergency fund.
But it’s important enough to bear repeating, so I’d like to explore ways to think about it here. When creating the fund you obviously have a choice about your goals – just what are you trying to cover with this fund? That will affect how much money you need. And this may change with time. You may choose to have a lower level of the fund while paying off debts or starting to invest for retirement, and then once you’re more on your financial feet in later years, increase your safety margin by adding to the fund. We’ll talk about these levels, and also some thoughts on how to manage your Emergency Fund.
Covering a major repair
One of the most basic ways to think of your emergency fund is to keep enough money that if something breaks, you can fix it without going into credit card debt or taking out a loan. This requires knowing what you have that can break, and what it costs to fix. For example, if you own a car, how much does it cost to fix a major problem (transmission, for example) with that type of car? Find out if you don’t know, Maybe you should keep enough around that if this happens you aren’t totally screwed. By contrast, if you don’t own a car but need a bike to get to work, keep enough cash around to buy a new bike of the same model if you somehow totally trash yours.
The same thought process should apply to your home. What’s the biggest repair you might actually have to pay for? Maybe nothing, if you rent. If you own, probably your stove, plumbing, or refrigerator. Only people financially secure in all areas of their lives will attempt to keep an emergency fund large enough to pay cash for something like an unexpected roof replacement without a loan, but more common problems might cost a few hundred to a couple thousand to fix and these could easily be dealt with by using an emergency fund.
This is a list of some common repairs to consider. The average cost will depend on the make and model you own, and possibly where you live, but you should be able to easily Google that when planning your fund.
- air conditioner
Your approach should be to save enough to cover the most expensive one that might happen to you, or maybe a little more to be safe. It’s not likely that four will happen at once.
Covering the health care deductible
Another way to think about this, at least for Americans, is to think about their health care deductible (link) or maximum Out-of-Pocket. What is your possible OOP in a given year? You will probably feel a lot less stress about this possibility if your emergency fund is large enough to cover the whole thing. Then even in a medical emergency, you’ll know you can cover everything you’ll be charged.
Covering a certain amount of time
The last common way to plan the amount is to cover a certain amount of time. This method is generally used when you have relative financial stability – you have no or low debt, for example – or when you have other people depending on you, such as a stay-at-home spouse or children. The idea is simple – you keep enough money on hand to survive for a certain amount of time if you lose your income.
Knowing what that amount is requires having a good understanding of your own budget. It also means you should think about how you want to live for those months. If you keep an emergency fund for 3 months of expenses, is that normal expenses? Or will you plan to cut back on optional expenses for those months?
The benefit of a fund for a certain number of income-free months is peace of mind. It means you know that you don’t have to immediately panic if you lose your job. And it means that if you have financial dependents, you and they know that everything won’t fall apart the day after money stops coming in. It’s easiest to trust someone when you know they have a plan.
The exact amount of time you are planning for depends on you and your spouse’s comfort level with risk and lifestyle change. It’s something you should think about and discuss. Realistically how long would it take you get another job? How long would you want to be able to keep looking without having to take anything that pays? Would you be ok with reducing your lifestyle during the interim? All these will affect how much you think you need. For reference, common benchmarks are 3 or 6 months covered. Sometimes risk-averse people go as high as 12 months. You should pick the amount that lets you and your wife feel safe.
Where to keep the fund, and how to handle it.
The other parts of the emergency fund plan are where to keep it and the rules for touching it. The most basic rule is this – the emergency fund is for emergencies only. That means not for an awesome grill, or vacation for your honeymoon, or prom dress for your daughter. Save separately for those expenses. If you cheat on the emergency fund your poor discipline is at best losing you money and at worst will put your family in a bad spot when something goes wrong and the fund isn’t full up.
For some people this will not be hard. They are not tempted and can just keep the fund in a savings account in their normal bank. But you need to know yourself and your wife. If you will be tempted, put your fund in a different bank from the one you normally do your banking with, so it’s not easily connected to your electronic stuff. If it’s still hard, put up painful barriers. Keep everything in a savings account with no card, and a separate checking account attached to a debit card so you have to transfer money into it when you need it. Maybe have a physical checkbook only so you have to go get it. Or keep your debit card frozen inside ice in your freezer, so you have to plan to get it out and can’t impulse buy. Another idea is to put your money into a CD account instead – these have penalties for early withdrawal, so you’ll need to be willing to take the sting when you really need it.
If you are married, you should also have an agreement that no one touches it without it being a joint decision to declare a state financial emergency. And in any event, your policy must be to refill the fund as fast as you can after using it , or it won’t be there for the next problem.