Four in 10 adults in America couldn’t cover a $400 emergency unless they were to sell some of their possessions or go into debt.
If you don’t have the cash to cover an emergency, you’re taking a big risk because unexpected expenses are inevitable. In fact, one study conducted by Pew Charitable Trusts found 6 in 10 American families had experienced a financial emergency in the prior 12 months. The median cost of these emergencies was $2,000 — five times the cost of the $400 emergency that 4 in 10 of us can’t cover.
You don’t want to find yourself in need of cash you don’t have, which is why you must have an emergency fund. While it can be hard to figure out how large that fund should be, we’ll help you decide how much to save in case bad luck hits.
WHAT’S THE RIGHT AMOUNT TO SET ASIDE?
It’s impossible to know how much an emergency will cost you, but it’s better to be over-prepared than under-prepared. That’s why most financial experts recommend your emergency fund contain enough money to live on for about three to six months.
This should be calculated based on essential expenses you’d keep paying in times of hardship. Have enough to pay for housing costs, food, utilities, insurance, transportation, debt payments, and personal expenses. You don’t necessarily need to save enough to ensure you can keep eating out twice a week or to cover other entertainment expenses. It’s the must-pay expenses that matter.
An emergency fund with three to six months of living expenses could sustain you if you suffer a serious medical issue, can’t work for a while, and aren’t eligible for disability benefits. Or, if you lose your job, it could give you the money to keep making mortgage payments until you find new employment.
In other words, it could mean the difference between a brief period of financial hardship and long-term financial disaster.
HOW SHOULD YOU DECIDE WHETHER TO SAVE THREE MONTHS OR SIX MONTHS OF LIVING EXPENSES?
There’s a pretty big difference between saving three months of living expenses and saving six months of living expenses — so what size emergency fund is right for you? The answer depends upon how vulnerable you are to a financial emergency.
Your emergency fund should be more substantial if:
- You’re the sole or primary breadwinner
- You have an unstable job
- It would take you a long time to find a new job if you lost your current position
- You have no other money saved for car or home repairs
- You aren’t very healthy
The more likely it is that you’ll lose your sources of income or need lots of money to pay surprise expenses, the bigger your emergency fund should be.
ARE THERE SITUATIONS WHEN A SMALLER EMERGENCY FUND MAKES SENSE?
While saving three to six months of living expenses in an emergency fund is a good rule of thumb, it takes a lot of time and financial discipline to put aside this much money. And, there is one situation where you may not want to set this big goal right away: when you have a lot of debt.
If you owe a lot of money, you still need to prioritize building up an emergency fund before paying extra toward debt. If you don’t, you can’t break the debt cycle. While extra payments could help your balance drop, a single bit of bad luck would lead you to break out your credit cards again. This creates a never-ending cycle where you never make real progress — and there’s a big risk that you’ll give up on aggressive debt repayment.
To avoid this problem, save up a “baby” emergency fund, then switch to bigger debt payments. The amount of your mini emergency fund will also be determined based on your personal situation. Saving $1,000 to $2,000 is a good rule of thumb, and you should aim for the larger amount if income is uncertain or there’s reason to believe you’re at high risk of costly emergencies.
When you’ve saved your mini emergency fund, shift focus to paying your debt — although if you spend your fund, go back to building it up again. After debt is paid down, finish saving enough so your emergency fund covers the recommended three to six months of expenses.
AN EMERGENCY FUND HELPS YOU STAVE OFF FINANCIAL DISASTER
As much as we’d all like to, it’s impossible to stop adverse events such as job loss or sickness. While these events can occur any time, an emergency fund helps you cope with problems without going into debt. Start saving for your emergency fund today so you’ll have the peace-of-mind of knowing you’re financially prepared for whatever life sends your way.