Life is iffy, that’s why we all need an emergency fund amount to see us through tough times. But how much? How to we save it if we are spending almost everything we bring in, or worse, spending more than we are bringing it?
As a rule of thumb, financial advisers suggest a enough money in an emergency fund to carry you for three months if you are employed and six months if you are self employed. Others suggest a one-year emergency fund for all. A highly successful contractor we know recommends a 2.5-year emergency fund. He has seen it all and once had to use that 2.5-year fund. In recent years he built a strip shopping center on property in front of his office/warehouse building with money from his emergency fund. He considers that monthly rental an adequate emergency fund for now. He says that he does not need the net rent coming from these five stores so he is again building up his 2.5 emergency fund as well. For most of us, probably a six-month emergency fund would be adequate so long as we are not struck with a true disaster.
What is an Emergency Fund?
What is an emergency fund and how does it differ from perhaps your 401k, your checking account or your credit cards that are not maxed out? An emergency fund is just for that–emergencies, nothing else. Those emergencies include:
Monthly living expenses if you are terminated from your job or lose a big client, if self employed;
Emergency medical expenses (consider setting up a healthcare savings account or HSA as part of your emergency fund to cover qualified health costs and get a tax deduction and a flexible spending account FSA;
Emergency auto repairs;
Emergency legal expenses or bail;
Emergency property damage;
Emergency damage from acts of nature;
Emergency resulting from acts of terrorism;
Deductibles on medical expenses;
Deductibles on property insurance
How to Create an Emergency Fund
If you and your significant other are each bringing in $15,000 a month and have excess funds, you already know how to create an emergency fund. If, however, you are more on the edge and spending almost everything that comes in or worse, overspending, then creating an emergency fund will be more difficult.
The best way to go about it is to:
Create a monthly budget that allows you to live on what you bring in each month without having to dip into credit cards or savings to pay your way. That monthly budget should also include those once or twice a year expenses like property taxes and insurance payments. The insurance payment that comes due in May should not come out of the emergency fund. It is not an emergency, it is part of your monthly budget process.
Think of your credit cards only as “convenience cards.” That is a tough change in thought patterns for most of us. They should be a convenience to you, not a piggyback. If you use them, make sure that you pay them off at the end of the month. (If you are currently in debt, as you pay off your credit cards, put the excess into your emergency fund. For example, if you are paying $99 a month on one credit card and finally get the balance down to zero, put that now freed up $99 a month toward your emergency fund. When your emergency fund is fully funded, put that $99 into long-term savings for retirement.
Even if you cannot make a big donation into your emergency fund at the moment, start off small. Start off as small as you have to but start, even it is $5 a month. Get into the habit, get thinking about that emergency fund and you will find other ways to add money, perhaps in the not-to-distant future. How? If you are commuting to work by car alone, find one to three other people to carpool with you. Right there, that will free up serious dollars for your emergency fund. If you buy lunch everyday, bring it to work with you. Turn off the lights and save on electric. There are a hundred ways you can begin adding to your emergency fund soon. Find every way you can to cut controllable costs.
Make payments to your emergency fund automatic so you don’t have to decide each month if you can “afford” to make a donation to it this month. If there is an easily accessible savings plan at work, us it.
Keep your emergency fund accessible for quick us, but not as accessible as your checkbook and not as distant as your 401(k).