Our featured article of the month, How To Build an Emergency Fund, helps outline the steps needed to setup an emergency fund. Determining the amount you should set aside is one based on your monthly expenditures. An easy rule of thumb is, what do you need to pay to ensure you don’t get yourself into a bind. Mortgage, taxes, utilities and food are certainly a good start. Then multiplying that figure by the number of months you feel comfortable holding.
Planners certainly recommend larger amounts due to our training and our experience. However, to each his own risk tolerance, but likely not less than three months worth. Also, the emergency fund was a tougher pille to swallow when rates were artificially low for a decade and a half. However, now that they are more reasonable, at least for now, the pain experienced holding safety money is considerabley less.
Money market accounts and funds are proving to be a good place for savings in the current interest rate environment ever since the FOMC began its rate normalizing program in mid 2022. Recently though, the reversal of that policy has been signaled and savers must understand that short term rates that affect money market funds are highly sensitive to these policy adjustments. Bank money market accounts are also sensitive to short term policy adjustments, but banks have much more discretion on the terms of their offerings. Unfortunately, they withheld raising rates on their offerrings until it became unfavorable to business conditions.
It’s a key component of any sound financial plan
KEY TAKEAWAYS
- An emergency fund is a key component of any good financial plan.
- The rule of thumb is that you need to keep between three and six months’ worth of household expenses in your emergency fund.
- In order to populate your fund, you should find ways to economize and contribute those savings—along with any financial windfalls—to it.
What Will You Need?
While some call having one to two months’ wages in reserve ideal, most financial experts say that the recommended emergency fund amount should cover three to six months’ worth of household expenses. That’s a great idea, and a key part of any sound financial plan, but it also requires some effort to achieve.
The first step in the process is to figure out how much you spend each month. Consumer expenditure figures released in April 2019 by the U.S. Bureau of Labor Statistics indicate that the average annual expenditure per consumer unit, which is similar to a household, was $60,060 in 2017 (the most recent year for which data is available).1 This data is broken down by month in the table below. The months in bold highlight the cumulative quarterly expenses, and therefore, the recommended cash reserve for the average household.
While your household expenses may be higher or lower than the average, there’s no doubt that even three months’ worth of expenses is a big number. One look at that number and the average person’s first reaction is, “I can’t come up with that kind of money.”
Why So Much?
The amount of money required to populate a proper emergency fund is certainly significant, but we live in uncertain times with uncertain economies, especially in the wake of the coronavirus. Corporate loyalty is a thing of the past, and unemployment can happen unexpectedly, usually at the worst possible moment. Even without a global crisis, emergencies such as sudden illness or disability, major car repairs or a new roof, can be expensive, and there’s never a good time for these things to happen.
While it’s probably true that you don’t have an extra $15,015 lying around, everything is relative. Even six months’ worth of expenses is a puny number compared to the amount you will need to save for retirement, and there’s not a savvy investor out there who balks at the idea of stashing away so much money that they will never need to work again. When compared to what you’ll need over the course of 20 or 30 years in retirement, three months’ worth of expenses doesn’t look like much.
Crunching the Numbers
With that perspective in mind, let’s consider how to save for an emergency fund. Approach this effort the same way you would approach any other financial goal. Put together a plan and execute it. The first step is to determine how much you spend each month. Housing, transportation, and food will likely be the categories that eat up most of your cash. The average household spends 62% of its income, which averages $73,573 before taxes, on these items, according to the BLS Consumer Expenditures report.1
Once you know your total expenses for each month, multiply that number by three. Reaching that number will be your initial goal. To achieve your three-month target, you need to start saving money.
If we assume your initial goal is $10,000, the table below illustrates how much you will need to save each month, over a five-year or two-and-a-half-year period.
Putting Your Plan into Action
Buying a less expensive car the next time you are shopping for an auto and downgrading your cell phone service are two easy ways to come up with some cash to fund your savings plan. Skipping that two-week vacation, cutting down on the amount you spend dining out, and saving your next raise or bonus are also achievable methods of adding to your emergency fund.
The key is to add to the fund at regular intervals. Ideally, you should treat it like any other recurring bill you must pay each month. Dedicate the appropriate amount from your paycheck and set it aside. While most people have no qualms about regularly sending enormous amounts of money to credit card companies, they balk at the idea of paying themselves first. Change that equation.
If you are among the many investors who don’t have a rainy day fund stashed away in case of emergencies, there’s no time like the present to start saving. Even if you don’t have the fortitude to address the project with a dedicated savings program, you can start simple: Take the change out of your pockets at the end of the day and put it in a jar. Look into micro-investing platforms, such as Acorns, that round up purchases made from linked accounts and collect and invest the change.
You could also eat at home instead of dining out and “tip” yourself by adding a few bucks to your emergency fund. If you get cash back on your credit cards or just paid off a big debt, such as a personal loan or an automobile, put that newfound money into your fund. If you get a tax refund, deposit the check into your fund. If you manage to dedicate just $5 per day to your effort, you’ll have $1,825 at the end of the year; that’s $9,125 in just five years.
Where to Put the Money
Money market funds and high-interest savings accounts are two good places to park your emergency fund. You need safe, liquid options so that your money is accessible in times of need. These choices make it harder for you to dip into it (face it: you’ll be tempted to from time to time), and you’ll also earn a bit of return on the money.
The Bottom Line
View your emergency fund like an insurance policy. Once you have it, guard it carefully. It’s not a piggy bank. You should not using it for incidental expenses. In fact, as your salary rises, be sure to up the amount to match your new situation.
Use the fund only in the event of an emergency and spend it carefully when you do need to draw on it. Remember, once that money is spent, it always takes much longer than anticipated to replace it. Start now and save whatever you can, even if it isn’t much. Having an emergency fund gives you a better shot at weathering a crisis without running up a credit card balance or taking out a personal loan.
1. https://www.bls.gov/opub/reports/consumer-expenditures/2017/home.htm
2. https://www.investopedia.com/personal-finance/how-to-build-emergency-fund/