An emergency fund is something that many people create as a preliminary part of their planning efforts for getting out of debt. I understand that in the event of the unexpected, it's nice to have something to fall back on. The big question is how much should it be so when I need to throw the emergency switch, I'll have enough to do what needs to be done.
There are many who advocate $1,000 as an emergency fund. I think it's a
great beginning, but in my mind, $1,000 is just a starting point. I
think many also view it that way, it's better than nothing, but only a
place to begin.
Think about it...how many days in a hotel and renting a car and eating out will $1,000 provide for you (and your family)? When I traveled extensively as part of my business, it wasn't any trouble at all spending $1,400 to $1,800 for travel and living expenses for a one week trip, even when I was trying my best to minimize expenses.
In my mind, $1,000 just doesn't provide you with many options. As I like to say, money gives you options...more money, more options. So, I would encourage you to think about having a more substantial emergency fund, perhaps $5,000 or even much more.
It seems reasonable to start with an assessment of what type of emergency we might encounter that would require a pile of money. Well, there are many to pick from, and perhaps it's best to narrow the choices down to things that are reasonably likely to happen. In other words, based on your experience, the experience of others, or your own educated guess, you can articulate good reasons why a particular event is likely to occur in your lifetime. Remember, the events need to be reasonable for you and likely to occur.
A few years ago I had a chance to sit down with a financial adviser
while he was counseling one of his elderly clients about how much that individual
might want to keep on hand, in the bank, in the event of emergencies.
Silently, I thought to myself, as a ballpark figure, he might suggest
$25,000 to $50,000. His suggestion matched my guess well enough, he
simply said, "I'd keep $50,000 minimum."
To most of us, that seems like a lot of money, and it is, but for an elderly individual who might need to have most things done for them, this isn't such a large pile of cash. As the adviser explained, "What if you need a new roof or a new car?" When I think of the $45,000 price tag on a new pickup truck, or the $75,000 price tag on a luxury SUV, or the $25,000 bid to install a roof on my house, I can imagine how a natural disaster causing damage to home and vehicle might deplete $50,000 in a relatively short time.
From one perspective, $50,000 isn't a lot of money.
I've said all of this to get you thinking about your emergency fund. If you had a major home repair, an unforeseen medical expense, or you had to replace your vehicle, would you have enough on hand to do that? Or, would you have to go into debt to recover from the emergency, or simply go without?
We all know, if our child gets injured and they need immediate medical care, we're not going to allow them to go without. It's just not an option to consider. And, that's only one of the many reasons why we might need an emergency fund.
If you don't have an emergency fund, you should start one. If yours is modest, you might consider bumping it up a bit. Think about the following:
The amount of readily available cash you keep on hand -- preferably in the bank -- is up to you, and largely depends on your circumstances. You might even be comfortable going without a formal emergency fund altogether. The only truth of the matter is one size does not fit all.
It's only fair to give some guidance about what kind of emergency reserves one might keep on hand. I'm happy to give you some specifics and the reasoning behind the amounts.
Let's look at what I think of as baseline reserves - money that you need to have on hand in a liquid state so you can respond to abnormal events, foreseen and unforeseen. Wouldn't it be nice to have a separate account for such matters? It would allow us to move quickly towards resolution of the problem simply by writing a check. Oh how convenient would that be.
We would hope the day of need would never arrive, but if it did, you'd be ready and able to handle the situation.
Here are examples of what we ought to consider, with the specific amounts simply pulled out of the air:
Having three deductibles and a co-pay doesn't mean we need three piles of money, as one pile can serve all potential needs. But wait, we're not finished.
In addition to insurance deductibles, we might also need some operating capital for:
Okay, so there is more to consider than simply insurance deductibles and co-pays.
The biggest single need on our list is money to keep us afloat if we lose our job or if we have a slump in our self-employment. There are those who think that six month's worth of income is the right number to shoot for to have sufficient cushion should you lose your job. I think that's a good figure to use.
So, if you're earning $35,000 a year and you want to have an adequate emergency fund, I'd look at the largest cost among all of the expenses, other than job loss, and then add that to my job loss number to arrive at a decent number for an emergency fund.
In this example, the largest insurance deductible is from a homeowners policy, and it's $5,000. Six month's of income is $17,500. So, we'll need to have $22,500 as a robust emergency fund. Keep in mind that this assumes that not every contingency will occur at the same time, or even during the same year, so you'll have time to build the fund up, and time to replenish it should you have the occasion to dip into it.
Even with higher income earned over the passing years, we might establish $35,000 annual income as the level at which comfortable living is possible. In other words, you might live like you're making $65,000, but when it's time to tighten your belt, you can regroup and live in a manner that $35,000 a year would support. This approach would allow you to keep an emergency reserve of $22,500, even if your income rose significantly.
Of course, this means you'd have to live in a more frugal manner, despite having substantially higher income available for discretionary purposes. And, that's exactly what I recommend to others who are wondering how to survive a recession...simply live like you're in one all the time. When it settles in around you, there won't be any need to change your lifestyle.
Except in the event of a natural disaster or other emergency that makes getting to the bank impossible, keeping your emergency fund in the bank is the best idea. Although having cash is handy, the safest place to keep your reserves is in the bank.
In the event of most emergencies, it's possible to pay for things (or at least make a down payment) using a credit card, and then use the funds you have in the bank to pay off the card when it comes due. Just be aware that during times when communications are knocked out, the only thing that will work is cash.