Planning for the Unknown Bad: Your Emergency Fund
The emergency fund is one of the most referenced concepts in personal finance media. In fact, because of how often it is discussed, there is little likelihood you need a detailed definition to understand the core concept. Simply, an Emergency Fund is a pool of money you’ve set aside in case of a crisis, such as you or your spouse losing their job or totaling your car.
Emergency Fund Size
There is a lot of confusion and debate about how much money should be in the emergency fund. The ‘rule of thumb’ advice you see in most articles and blogs is generic one-size-fits-none advice that doesn’t consider the specifics of your financial situation. To calculate the total amount you should have in your emergency fund, you’ll calculate two distinct ‘pools’ of funds for the different types of emergencies you might have.
Insurance Deductible Fund
The size of the first pool of your emergency fund is based on another tool you have to help with emergencies: insurance. You may have insurance for various emergencies including car accidents, major health issues, and your house burning down. Insurance policies don’t pay 100% of the cost to remedy any of these situations, though. Your portion you must pay is called the deductible.
Start by gathering all your insurance policies and calculating the maximum deductible for each one. Since you will have to pay for these deductibles out of your own pocket, it is wise to make sure you always have the money to afford your portion of an emergency. Add up all the deductibles on each policy to get your worst-case scenario for deductibles.
A riskier option would be to choose the insurance policy with the highest deductible and save that amount. Saving for the largest deductible might be a good first step in building your emergency fund, but it likely won’t be enough to cover your family. Unfortunately, emergencies tend to be pack animals and come at you in groups. If the health insurance deductibles from a car accident drains your emergency fund, it won’t be able to cover the car insurance deductibles.
Income Replacement Fund
The second pool of money in your emergency fund is designed to replace your income if you or your spouse lose your job. Most ‘advice’ suggests having three to six months of expenses for this fund, but little direction explains how you determine if it should be three, four, six, or more months; or even what constitutes an ‘expense.’
Determining the ‘Per Month’ Amount
First let’s figure out your ‘baseline per month,’ and then we can deal with how many months you need to reserve. Start by listing your budget and identifying the expenses you would want to preserve if your family experienced loss of income. Obviously, paying for housing, utilities, food, and loans will likely be on this list. But also consider what ‘fun’ expenses you would want to keep. Your emergency fund shouldn’t allow you to just barely survive a crisis. It should let you get through a job loss without affecting your ability to live the important parts of your current lifestyle.
Determining the Number of Months
Once you know the ‘per month’ amount, you must determine how many months to multiply to get the needed fund size. To determine how many months of an emergency fund you will need, ask yourself a simple question: how long might you or your spouse be out of work? If you both work in high-demand careers like nursing and computer science, an emergency fund of three months is probably all that is required as you would easily be able to get a new job within that period of time. The longer you think you need to accommodate a job search, the more funds you need.
Some professions, like construction, can have long periods of unemployment as a routine aspect of the job. Consequently, even a six-month emergency fund may not be enough. If you haven’t had a recent period of unemployment, look at the last job search you conducted and hiring statistics for your profession on job listing websites. The average time it took you and others to find gainful employment is probably a good indicator of how long it would take to find new jobs.