Is There a Correct Emergency Fund Amount? Different Ways to Calculate How Much You Should have Saved?
Home/Personal Finance/Is There a Correct Emergency Fund Amount? Different Ways to Calculate How Much You Should have Saved?
Having an emergency fund is probably one of the most important things you could for your financial well being. If there was a hierarchy of personal finance, it is likely on the bottom with owning life insurance as not to bankrupt your family if you were to premature predecease. However, there are just a ton of different opinions on just how much should be kept in cash.
What is the Wrong Amount to Have in an Emergency Fund?
Although linked and studied, it isn't whether those numbers are exact or not, there is a bigger picture. We can't pay a $400 emergency but luckily we are covered to watch ESPN the Ocho both in and out of our house.
With those payouts and inflation hovering between 2 and 4% depending on what source you want to believe there is an easy case that, yes, there can be too much cash in an emergency fund. Obviously there is a difference if you are going to be using the cash in the short term, but we are just focused on how much should be in your emergency fund.
What is the Correct Amount?
I honestly do not think there is one correct answer, but rather three separate ways to look at the puzzle.
The first way to answer the question of determining an appropriate amount to save in an emergency fund is to take some multiple of your gross monthly income. That number is usually 2, 3 months or 6 months. Let's say you have an extreme emergency like a disability where you are unable to work, this number would come in handy because, mentally, it may feel like you are still working.
The Pro is that it is simple. Take your annual salary divide it by 12 and then multiple the amount of months you want to have. The con is that it may be wildly inaccurate with regard to need. Maybe you have too much because you are a saver (see above) maybe you have too little because at the current time you are running a deficit.
But what about those that do not spend their entire net income nevertheless their gross? For example why should I have 3 months of gross income if I am only spending 80% of my net income (i.e. 80% of the 80% after tax income)? In those cases people may feel safer having multiple months of expenses saved. Again, the amount of months is a personal decision.
It is amazing to me how many people think they spend less than they do.
This method can be used by those that really understand their personal finances. The amount is chosen at the amount of cash that is needed if the crap hits the fan moment. To me, this is the most advanced of the calculations because someone really needs to know themselves and understand their personal situation. The pro is that by its very definition it is the optimal amount allowing someone to feel safe and sleep at night. The con, is that if not done correctly it could be disastrous. I would not recommend this method for most people.
How Did my Family Determine the Cash Necessary for its Emergency Fund?
The Wife and I went with the "being able to sleep at night" method. The amount is less than a few months income and expenses, but it still allows me to sleep and cover any quick housing emergency. I have used it a few times in the past few years, but the last time was when our air conditioning unit went – I was able to offer the AC Guy cash to get a discount. The remainder of our emergency money is held in very liquid securities.
We are in the sleepwell category, aiming for one year of expenses in cash.
With the current interest rates, that Hurts.that being said, savings accounts will almost always loose from inflation.
In a few years, some of my I insurance accounts start to act like savings accounts. They keep better up with inflation.
I'm in the sleep well category as well when it comes to my emergency fund. I like to keep it constantly building up, so I put in a small amount even few weeks automatically. I don't notice the money and my emergency fund stays nice and topped off.
One good thing about basing your emergency fund off what you spend is that, even if you underestimate it, most people will still probably cut back on their spending in the event of a job loss (at least I hope they do). So even if you underestimate, you could still be fine with an estimate as to what you spend per month.
Once you have any amount of cash saving it helps you sleep better at night. We carried a $1k while paying off our debt and found it covered most emergencies. The size of the emergency fund is a personal decision. I do like the expenses approach for a 6 to 1 year period. Just image if you main income was gone for a period of time which I think will help you decide.
Depending where you are in the world $1k may be fine, I just know any house problem I have is a multiple of that!