An emergency fund is a separate savings account that we set aside to cover monthly expenses in an emergency situation. If we experience a layoff or we’re unable to work for a period of time, the emergency fund is there to provide a financial cushion or safety net until our situation changes for the better.
Recommendations for the amount in our emergency fund are typically based on our monthly expenses and the number of months that we might be without income. Some advisors recommend three months’ worth of expenses, others say six months, and still others say that our emergency fund should be large enough to pay our expenses for a year. Frankly if I don’t have an emergency fund, then my first goal would be to save three months-worth of expenses, and then I would increase it to six, and so on depending on my job skills and employment potential. If I have a unique set of skills that are in demand in the job market, then I might expect to be out of work for a month or two. Otherwise I might find myself out of work for six months to a year, or even longer. Many people have experienced an extended period of unemployment, and then have found a position but at a lower salary. In this case, an emergency fund can provide the additional monies needed to make ends meet.
One issue that I see with determining the emergency fund amount is that many people don’t have a comprehensive budget that includes all of their expenses. Items that aren’t typically paid monthly are often forgotten, like car insurance, life insurance, or bills that are paid quarterly or even yearly. For some people their budget is as simple as direct deposit of their paycheck, and all bills paid automatically from there. In this case, they really don’t know their monthly expenses, and can’t see areas where some cost-cutting could be applied. If we have a budget that includes what we actually pay in expenses (all of our expenses), then our budget amount can be used to confidently determine the size of our emergency fund. If not then we should first get a handle on our expenses.
A budget is not a list of limits for spending or buckets of money that we set aside for expenses. A budget shows what we actually spend and where the money is going. If we don’t know where our money is going, there is no way for us to manage our finances and plan effectively, and saving turns into a start-and-stop exercise with frequent withdrawals to make ends meet. A budget must come before any savings plan, so that the saving amount is allocated specifically for saving and isn’t needed for expenses.
Once we have a true picture of our expenses, we can determine a comfortable amount for our emergency fund based on the number of months that we want as a cushion. The table below shows some examples for three, six, and twelve months’ of expenses for various monthly amounts. I have included the monthly savings amount needed to accumulate the three-month emergency fund amount within three years.
Using the first row of the table as an example, if my monthly expenses are $1,800 and I’d like to set aside the amount to cover three months’ of expenses, then my emergency fund goal is $5,400.00. To accumulate this amount in three years, I will need to deposit $150.00 each month into my emergency fund. If I can save more each month, then I’ll reach my goal sooner.
The first step is to establish a saving goal based on our expenses and a number of months that we’d like to have as a safety net. Second, we make sure that regular deposits are going into the fund. Then, once our emergency fund is established, we need to remember that the money is only to be used for a true emergency situation.