One of the initial steps towards financial independence is to build your emergency fund. The concept is simple: you set aside enough liquid assets for the surprises of life. Calling it an emergency fund attempts to shield you from spending it frivolously by assigning it a purpose. Most often these life surprises are events like job loss, major auto repairs or urgent health expenses.
Let’s begin by reviewing the conventional wisdom regarding emergency funds, before diving into some of my opinions which shape how I calculate my emergency fund.
General wisdom recommends building your emergency fund in stages.
Stage one: Build your emergency fund to about $1000. This amount is enough to cover a majority of unexpected events. This first step is often used for people crawling out of consumer debt. If you have interest rates on debt over 8% then once you build this $1000 fund, all extra cash should be tasked with relieving you of that high-interest burden.
Stage two: Increase your emergency fund so it equals 3-6 months of your average expenses. At this point you are comfortably free of high-interest debt and slowly building your wealth. It would be a shame to fall back into the consumer debt cycle because you failed to save for the unexpected.
Building your fund to this level strengthens your ability to tackle a broader range or even simultaneous financial emergencies without worry. Your financial worries will subside. You will feel better from the reduction in stress and be able to find more enjoyment in life, or even work!
32% of respondents to a federal study indicated they would not be able to handle a three-month disruption to their financial life. An additional 21% would require borrowing or selling assets to handle this three-month event. [Report on the Economic Well-Being of U.S. Households in 2014]
The point is, start growing your fund now, no matter how slow, to avoid future stress and hardship. You only live once, so take control and make it your own!
Now let’s see what I am doing personally to maintain a healthy emergency fund.
I am past any high interest debt in my finances and therefore live somewhere in Stage two. From my monthly expense reports, I can safely say my average spending is between $1600 – 1800. By conventional wisdom, I would look at having a fund of $5000 for three months or $10,000 for six months.
I didn’t really discuss above, but this fund should be liquid, meaning instantly accessible. For me that means a high interest savings account, something like Ally or Discover. Recently, I have seen lots of discussion about conservatively investing some or all of your emergency fund. At this point I do not agree with this. The main reason being that as your wealth grows, the amount gained by conservatively investing your emergency fund is far out gained by your normal investments. Not a risk I would take.
Currently, my “emergency fund” is exactly $10,000. This is between the recommended 3-6 months of expenses. Below are my reasons why. (Some of these are theories and I will retroactively add data sources supporting or debunking each as I find them).
I am still paying down debt. I no longer have high interest consumer debt, and all of my debts are below 3%. Another aspect of conventional wisdom is to pay the minimum on such low-interest debts, but this debt (student loans) is highly emotional for me. Ridding myself of this debt is a personal goal and I am willing to take the risk of a smaller emergency fund as well as historically smaller gains.
I live in a job dense location. While this means COL is also higher than average, it also means unemployment duration is lower (this is a theory). If I think I can get a job faster than the expected 3-6 months, then I can take the risk of a smaller emergency fund. This factor will of course vary from location to location AND industry to industry.
I have a degree in STEM. My current occupation is highly technical and workers with my experience are desired. Whether this holds true in a recession I do not know. But, I feel comfortable enough with my degree and experience to find a job before my emergency fund is at $0.
I live in a DINK household. With two earners, the odds of both of us losing our jobs simultaneously are lower than a single person’s. Two incomes also provides a larger resource pool to diminish the distress of a financial emergency. No kids (but a few animals) means our base expenses are lower to sustain. All personal lifestyle choices, so your mileage may vary.
Extended family support. Like the 21% of survey respondents who could borrow money from family to cover a three-month emergency, I believe I could do the same. I would not want to do this, but I know my family would help if they could. Risk reducer.
Wiggle room in the budget. My monthly budget number is more than adequate for living. I know I could squeeze an extra 10-15% from those numbers without too much difficulty.
Miscellaneous assets. In a TRUE emergency I could tap into other financial assets like a 401k or IRA. In no way would I do this unless it was a TRUE and ABSOLUTE emergency. I can’t even think of an example when this would be as most other options are better mathematically.
The next point is one that caught me by surprise as I wrote this post.
Savings for other goals. My emergency fund is exactly that, money tasked with helping out during a surprise in life. In addition to my emergency fund I also have liquid savings tagged for other purposes.
Part of the YNAB philosophy, or any other envelope budgeting system, is to assign every dollar a job. During a true financial emergency, savings tagged and set aside for other financial goals would likely transfer to my envelope assigned to emergencies.
For example, I understand my car requires periodic maintenance. Therefore, I set aside small amounts every month for that purpose. But those dollars are tagged for auto maintenance, not emergencies. But in the end, it’s just a label.
So through understanding my expenses, my system is really a collection of mini emergency funds! (This is why I started this section with the words emergency fund in quotes)
My main emergency fund is sized for if I lost my job. But I also have mini funds growing or stabilized at certain values for auto maintenance, home repair, medical bills and animal care. Most of these funds are oversize because predicting the required amount is not possible. Hence, their similarity to a true emergency fund.
If these savings goals are all taken into consideration, my collection of emergency fund type funds, is much more than the recommended 3-6 months expenses! It was a long road to get to this stage, but my emergency fund is sized exactly for me! It takes into account the current state of my debt, my risk tolerance, my support system and lifestyle choices.
To me this highlights the importance understanding your financial lifestyle. Without being aware of it, I have taken the conventional wisdom and fitted it to my situation. I adapted my finances to suit my personal requirements. To me this is what personal finance is all about.