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Chances are, you know you need to create an emergency fund to help you survive financial emergencies. However, if you research how big or small this fund needs to be, you will find contradictory advice, much of which is flat out wrong or at least incomplete. The following is how I figure out how much I need to set aside, which should help you figure out your “perfect fit” emergency fund size.
Dave Ramsey suggests your emergency fund be $1000. If your kid suddenly needs a cavity filled, your car’s alternator goes out, or something of similar magnitude happens, $1000 should be fine.
However, that’s not a real financial emergency. It’s just life happening.
A true financial emergency is if, heaven forbid, you become temporarily disabled due to an accident or severe illness, or you lose your job. In such a situation, $1000 is not even remotely enough to tide you over. If $1000 is all you have saved up, you’ll run out of cash and out of options before the week is out! If you’re really frugal, you may stretch that out to a month.
Suze Orman, another well-known ‘financial guru‘, on the other hand, says you need to set aside 8–12 months of your income. While in some cases that’s true, it’s sort of like pulling an XXXL shirt off a store rack and saying that it will be large enough for you. Sure, that shirt will be a perfect fit for some, but it will be grossly over-sized for most.
Orman is right to state things in the number of months, but misses the mark in two important ways. First, by saying that 8–12 months is the right number for everyone, and second by using your income as the measure of what you’ll need to replace.
To get the real number that’s right for you, let’s figure out how many months you need to worry about, and what number of dollars you need to account for in each of those months.
As I’m sure you can intuitively understand, if you’re a single parent to several small children, have no family support, and your income isn’t stable, you have a far greater risk of a financial emergency devastating you than if you’re married, have no kids, both you and your spouse have solid jobs with stable employers that pay good salaries, and if push came to shove, your family will help you out.
That’s why nobody should give a set number of months, whether it’s 3, 6, 8, or 12 months, or even a set range like 3–6 or 8–12 months.
We have to accept that any number of months short of the likely remainder of your life will not provide a 100% guarantee that your emergency fund will not run out under any plausible circumstances. If you can create such a giant emergency fund, you can probably already retire, and don’t need my advice (in fact, maybe I could use yours ????).
The problem is that almost none of us can create that size fund anytime soon. That’s why you should look at your personal circumstances and decide on a range of months that makes sense given the following factors:
For example, if all the above is true for you except that you’re single, 6–9 months would be better for you. If you don’t have too many financial responsibilities that can’t be swiftly downsized, but you’re single and self-employed, 9–12 months would be your better bet. If you’re single, self-employed, and have little flexibility in downsizing, shoot for 12–15 months.
The second critical question is what determines how many dollars you need to set aside for each of these months?
Certainly, if you can replace every dollar you earn, that’s best. However, that may be a much tougher target than you can hit, and importantly, it’s more than you need.
Your real need is to replace only enough income to cover your critical spending. That includes the following:
You’ll immediately notice that I didn’t include in these three major categories: income taxes, savings, and discretionary expenses. This is because if your income goes away, you don’t have to pay income taxes. You also don’t have any way to set aside money for savings if nothing is coming in. Finally, where you can trim the most — discretionary expenses, you should plan on cutting as close to zero as possible, at least until you’re back on your financial feet.
Now that you’ve calculated how many months you need to worry about, and how many dollars you’ll need to cover per month in an emergency, multiply the two numbers and that’s your “perfect fit” emergency fund size in dollars.
The number you come up with may seem undoable.
That’s ok. You don’t have to get there tomorrow, or even next year. Just get started.
Set aside some money from each paycheck, even if it’s only 3%. If you can’t do 3%, start with 1%. Anything can and will help. Then try to increase that rate each year by at least a little bit.
In addition, each time your income increases, whether it’s from an annual bonus, a holiday tip, a big cash gift, or a raise, divert at least half to your emergency fund.
Once you reach your emergency fund target, don’t increase your spending.
Instead, use the money you would have sent to your emergency fund to turbocharge your other savings for goals such as retirement, down-payment for a house, replacing your junker car, college for your kids, paying down credit-card debt, etc.
By doing all this, you help your future self by (a) increasing the resources you have available to you, and (b) preventing your financial obligations from ballooning over time, a.k.a. lifestyle inflation.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.