What your Emergency Fund should look like

by Tom Tousignant

in Blog, Financial Safety, Wealth Building

Most every financial adviser, financial book, or financial ‘guru’ will suggest that you need an emergency fund.  I agree with that, in fact, I place that as the highest priority in my StartwiththeHouse system.

Where a lot of people fall short is determining how much should be in an emergency fund and where should that money be kept.  It takes a few minutes, but there is a really simple way to determine how much needs to be in an emergency fund.

  1. Determine how much you currently spend each month.
  2. Decide how many months you could possibly go without income.
  3. Find a place to put the money.

1.  Determine how much you currently spend each month.  The fastest way to do this is to take the latest copy of your active bank statements and credit card statements.  Add up the totals of all your checking account withdrawals and credit card charges over a 30 day period.  Subtract from this number any transfers of funds, for example, if you moved some money from checking account to your savings account, don’t count that as part of your monthly spending.  Think for a minute of any annual expenses you have, such as insurance or property taxes.  Divide that number by 12months, to get the average per month for those annual bills.  Add this to your monthly total.  This number (Checks written, debit card and credit card charges plus monthly portion of annual bills) is your average monthly expenses.  If everything stopped coming in, this number is what you currently have going out each month.

2.  Decide how many months you could possibly go without income.  This number changes over time and is different for everyone.  If you are in a highly specialised job, you might expect a longer income loss after a layoff.  For many people, they could lose their job, and then be earning money doing something else in just a few weeks.

Your employment and income type also impact your emergency cash needs.  For example, a federal government employee is less likely to suffer a layoff for loss of income than a new business owner.  If you are in an industry that has frequent layoffs or is under duress right now (like airlines or automobiles), you will want to have a larger emergency fund. Your employment and income type could add 2-6 months more to your requirements.  (If you lost your job and would need a long time to find a new one, you need more emergency cash, for example).

Other factors to consider are: Age, current compensation structure, and income uniqueness.  Younger folks generally don’t require as large an emergency fund as older folks.  For example, a 23 year old college graduate still remembers how to cook ramen noodles, could probably stay with a friend, and if they have kids, really only need diapers and PBS television.  As you get older, kids get more expensive, lifestyle generally costs more, and monthly expenses are higher.  By the time you get to retirement age, your emergency cash needs are actually at their highest.  You will want a few years worth of cash available so that you can ride out any market fluctuations and not have to sell investments in a down market.  Your emergency fund based on your age should be 2 – 24 months of expenses, growing larger as you get older.

NEW YORK - MAY 20:  In this photo illustration...
Image by Getty Images via Daylife

Lastly, think of other risks in your life that could lead you to need some quick cash – older cars, for instance, which could need expensive repairs.

Based on the potential need for emergency cash, or the severity of the need, decide how many months you could see yourself without a steady income.  Set this as the target for your emergency fund time frame.

Now, take the amount of money you are currently spending each month and multiply it by the number of months you feel is prudent for you specific circumstances.  This gives you the amount of cash you want in your emergency fund.

3.  Find a place to put the money.  Where should you store this cash?  First of all, let’s talk about where not to put it – don’t put it at risk, such as in the stock market or stock mutual funds where prices can fluctuate.  If you do, you could find your fund worth much less just when you need it.  Don’t store it in your checking account – it’s too easy to get to and you may find it being frittered away over time.

I like to keep money like this where it is liquid – I can get to it, but somewhat solid also – meaning I have to do some work to get to it.  If I have to ask someone’s permission, that is even better.  (You know, I saw a great deal on this really nice motorcycle, and I had this extra money in my checking account…don’t be that guy!).  Over the past few years, I have been storing my real emergency money inside the cash value of a life insurance policy.  This is working perfectly for me – it grows each month, it’s always available within 2-3 days, but I have to ask my agent (who is also a trusted friend) for access to the cash.  I have ordered him to hang up on me if I call with a stupid reason for needing the cash.  The think I did different with this policy was that we designed it to build cash value faster than normal.  The other thing this does for me is obvious – if my family needed it – there’s a lot more there than just my emergency funds.

Much easier to get set up and funded, however, is an online money market account, like ING or E*Trade offer.  They are shielded from your day to day checking account activities and still liquid enough to get to.  Interest rates on these accounts are all low right now, but the purpose of this account is liquid cash, not earnings.

Key Point:  Set an exact figure for your emergency fund.  You need to know how much money that is, how long it would last in an emergency, and if you have saved it or not.

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