There’s an ongoing debate as to how large an emergency fund should be. The amount needed will be different for each person, for each household, but I’d like to look at the question from a different angle.
Rather than making a recommendation based on a flat amount, like $1,000, or so many months’ living expenses, I think it’s more practical to look at what it is an emergency fund should be expected to cover before determining how large it should be.
There’s no way to estimate how much money should be in an emergency fund without first defining exactly what constitutes an emergency worthy of tapping the fund. But let’s begin by focusing in on what it isn’t.
The World English Dictionary defines an emergency as “an unforeseen or sudden occurrence, especially of a danger demanding immediate remedy or action.”
Note the use of the words “unforeseen or sudden”; an emergency isn’t a routine or fully expected situation, like a shortfall in a monthly budget, routine car maintenance, or even replacing the roof on your house. All of those are fully predictable and require proper budgeting, but none are an emergency and shouldn’t be covered out of an emergency fund. If the fund isn’t held as a separate account with a clearly defined special purpose, it can easily degenerate into just another checking or savings account.
With that in mind, what emergencies should we be preparing our emergency fund to cover? Here’s the short list (and it should be short!):
Each of these are true emergency events that won’t fit neatly under an arbitrary allocation like three months living expenses, but would put you under a load of debt if you are unprepared.
Now that we’ve defined what an emergency is and what it isn’t, let’s take a look at how to prepare for them with a fund. We’ll use an estimate for each category, then total them at the end to get an idea as to how large the fund should be.
Job loss or income disruption. This is where we can apply the “so many months living expenses” rule. How many months that will be will depend on personal circumstances such as how quickly a job in your field can be replaced, what other sources of income the household has, or even the size of investment assets that can be tapped in an extended emergency. At a minimum, this portion should represent at least one month’s living expenses to allow time for unemployment benefits to take effect. For our purposes, we’ll assume this to be $3,000 per month, and we’ll go for two months, or $6,000 as a bare minimum. (Your personal situation may dictate needing 12 months of expenses saved up. Each situation is unique.)
Medical emergencies. You should have an amount in your emergency fund sufficient to cover the deductible portion of your health insurance. We’ll assume a $2,000 individual deductible, and include it in the emergency fund.
Auto accidents or theft of vehicle. Just as with health insurance, you should have an amount in your emergency fund to cover the deductible on your auto insurance policy. We’ll use $1,000.
Serious damage to your home. Again, the deductible on your homeowners insurance policy should be added to the fund. We’ll use $1,000.
Heavyweight car repairs. Get prices on what it will cost to perform the most expensive repairs, like a transmission replacement. If it won’t be needed in a time of emergency, you’ll have the money available for other purposes. If it is needed, you’ll be ready. Let’s assume $2,500.
Now let’s total it all up:
Total for emergency fund: $12,500
As you can see, the emergency fund calculation we’ve used here doesn’t fit neatly under any rules of thumb — we’re matching funds with probable emergencies.
This is of course a more detailed method of calculating the size of your emergency fund, and part of the reason is so that the fund isn’t any larger than it needs to be. Once true emergencies have been identified and prepared for, any additional money should be in investments that provide greater returns or utilized to pay down debt.
It isn’t necessary, desirable — or even possible — to cover every emergency outcome. For example, health insurance policies typically include an annual individual deductible and a family deductible — usually equal to two or more individual deductibles. You may want to cover multiple deductibles, but what are the chances that two or more members of the same household will experience high medical costs at roughly the same time?
The same is true of auto insurance deductibles — if you have two or more cars, there’s probably no need to prepare for accidents or theft of more than one car, especially if all drivers in the household have good driving records.
Even if either event did happen, your fund has allocations for multiple emergencies, some of which won’t happen in conjunction with others, so funds will be available just in case. In addition, greater concentration of funds in income producing investments can provide a second level of funding in a worst case scenario. In the end, while there are multiple reasons to have an emergency fund, the main purpose is to give you time to deal with what ever comes your way.
How do you determine how much you should have in your emergency fund?
Photo via Wikimedia Commons.
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