Emergency funds. Everyone has heard of them, and most of us know we need to have cash ready for unexpected expenses. But what many do not know is how much money they, specifically, should set aside.
A common recommendation among financial planners is to save 3 to 6 months’ worth of necessary expenses. Ok, but which is it? If you have monthly expenses of $3,000, there is a big difference between building a reserve of $9,000 and $18,000.
Once you know how to set up your emergency fund, you need to know how much to set aside. Here’s how to make the call yourself.
How to Calculate Your Monthly Expenses
Refining your specific number starts with knowing your monthly expenses in detail. Depending on how exact you want to be, here’s a 3-minute exercise and a 30-minute exercise to calculate your monthly expenses:
3-minute exercise – Take-Home Pay Minus Monthly Savings:
This quick two-step process provides a rough estimate of your monthly expenses.
Step 1.Add up your average monthly pay. You’re looking for the money you get after taxes, because that’s what you can spend. This will be very easy if you get paid twice a month on a salary, and more time consuming if you get paid on commission.
Step 2.Subtract your monthly savings. You won’t be saving or investing during an emergency, so subtract your average monthly contribution to investment or savings accounts.
What’s left (your take-home pay minus what you save), is a good starting point for how much money you need to live each month. It’s not exact, and will likely be a higher number than the next exercise provides, but it’s a nice shortcut.
30-minute exercise – Discretionary vs. Nondiscretionary Expenses:
To get the best estimate, review every expense from the last few months and imagine you didn’t have a job. How would your spending change?
You probably would cut back on “discretionary” spending, like shopping, dining out, and travel. You’d also pause all saving or investing until the job situation firmed up.
What’s left after cutting out the “nice to haves” is your “must haves.” This is the nondiscretionary spending your emergency fund should cover, like housing payments (or rent), car payments, gas, groceries, utilities, and health care. You may find that you’re spending $4,000 per month, but only have $2,800 per month in necessary expenses. That’s the number you’ll use in the next step.
Whichever road you took, now you have a monthly number to multiply by the right number of months for you.
How Many Months of Expenses You Need
The right number of months of savings depends on your situation. The biggest factors are if you are in a single or dual income household, and how many people depend on your income.
Target 3 Months of expenses if you are:
- Single with no dependents
- Married with no dependents
Target 6 Months of expenses if you are:
- Single with dependents
- Married with one spouse earning
- Married with dependents
Under some circumstances, you may want to squirrel away an additional month or two in your Emergency Fund.
Competitive Job Field:If jobs in your career are limited, extremely competitive, or openings with comparable pay are scarce, a larger reserve may be in order.
Commission Pay:Earning commissions can be a great way to increase your income, but they do make your pay less dependable. If 50% or more of your income is commission, an additional cash reserve can give you peace of mind and financial slack.
Have High Interest Debt? Build a 1-Month Starter Fund
If you have a large outstanding credit card balance, focus on saving 1-months’ worth of cash reserve. Then halt this step until you have paid off all bad debt, like credit cards and high interest student loans.
This financial lifeline keeps you from sinking further into debt if you face a financial setback. If your car breaks down, ideally your starter emergency fund should cover it. Once you pay off all “bad debt” you can focus on saving up a fully funded emergency fund, based on your numbers above.
Just Get Started
If the emergency fund you calculated seems like an impossibly high goal, just get started. Automate saving something for your emergency fund each pay period, even if it’s just $50 to start. Work towards one month and count off each milestone as you progress.
Be sure you open a separate account outside of your primary bank to hold your emergency fund. It’s too tempting to spend that hefty balance if you see it every time you log into your bank. Leave the money alone when you want it, so it’s there when you need it.
Once your emergency fund is topped off, you’ll be ready to tackle big and exciting goals in the future.