What Is an Emergency Fund, and How Much $ Should Be in It?
Like closely monitoring a budget and having regular health checkups, setting up an emergency fund is something we know we should do, but it often falls to the bottom of the priority list. For those with little savings in their accounts, experts worry that this can leave them open to serious financial strife if they were to lose their job, have a medical emergency, or even cover car or home damage costs.
It wasn't until I met with financial planner Jenn Imbeault that I realised backup funds aren't optional, they're vital, and they need to be tallied before any other expense. "Your emergency fund should be treated as totally different to your savings and everyday account," says Imbeault, CFP, Vice President, Fidelity Investments Shrewsbury Investor Center. When we tallied my monthly living expenses and income, I realised that the small amount I'd mentally set aside "just in case" wouldn't cut it in an emergency. In fact, it needed to be doubled.
Don't have an emergency fund? Follow these four steps to find out exactly how much money should be set aside. It takes moments, but it could save you from serious strife in the future.
Tally Your Take-Home Pay
An emergency fund is an account that sets aside money in case of a short-term financial issue, like losing your job or falling ill, so before building this fund, you need to know exactly what your income is. For some, that's an easy question, but if you're a freelancer or have multiple income streams, it may involve some research. Your take-home pay is the amount deposited into your account each pay period, less health insurance or any pre-tax expenses.
Itemise Your Essential Living Expenses
If you already have an itemised budget, this step will also be quick. If not, write down a list of all your essential living expenses; these are the costs that you absolutely cannot avoid, like rent or groceries. It doesn't include clothes shopping or sporadic purchases (unless you deem them absolutely necessary).
A few of the essential living expenses on your list might be:
- Rent or mortgage repayments
- Internet bills
- Phone bills
TURN GOALS INTO REALITY:
Question Your Comfort Zone
Now that you know what your monthly takehome pay and expenses are, it's time to make a gut decision. To determine how much money you should set aside, she recommends asking yourself one question: "If you were unemployed tomorrow, how much cash do you want to have on hand to live comfortably?" If you're confident you could find work in six months, your emergency fund should contain at least six months' worth of money to cover essential expenses.
"It really depends on how confident you are that you'll be able to bounce back," says Imbeault. "For some people I speak to, it's two months; for others, it's six months." The general consensus among experts is to save anywhere between three to nine months' salary to be safe. So, if you earn $4000 a month, you might want to set aside $12,000 for emergency expenses, which is the equivalent of three months pay. If your essential expenses are comparatively low, you might be comfortable setting aside less money, as you don't rely on your entire paycheck to get by. It's worth noting that setting aside too much has it's drawbacks though, as you likely won't be accruing interest on those funds.
Open a Specific Emergency Fund Account
Now that you know how much money should be in your emergency fund, open a separate bank account. This step is crucial, as it ensures you won't be tempted to dip into the funds. "You should absolutely keep your financial priorities separate," says Imbeault. "If you have a joint checking account that's used for emergency funds, savings, and to pay bills it's easy to blend it all together."
Open a fresh account, deposit the money, and stash the debit card away with your other important documents rather than in your wallet so you won't be tempted to use it. Hopefully, you won't have to turn to your emergency fund, but now you can rest easy knowing that if the unthinkable happens, you're covered.