There are countless rules of thumb out there meant to guide us in our everyday lives: Exercise at least thirty minutes per day for optimum health. Wait at least two days before calling after the first date. Don’t wear white after Labor Day.
While there are exceptions to all of these rules, they are generally good guidelines to help make decisions. Similarly, there are financial rules of thumb in the financial planning profession that we then customize to each person’s goals and values. For the next several weeks, I’ll be sharing six that we regularly use at Financial Finesse to answer these common questions:
- How much should I have in my emergency fund?
- How much do I need to save for college?
- How much do I need in order to retire?
- What percentage of my income should I save?
- How much life insurance do I need?
- How much house can I afford?
Let’s start with number one. How much should you have in your emergency fund? The general rule of thumb here is three to six months of your expenses.
However, you may need more if you own a home that could potentially be hard to sell, work in a field that is highly volatile or specialized or have a large family dependent on one income. When real estate prices plunged along with a lot of people’s job prospects during the last recession, twelve months would have been more appropriate. That’s how long it took many people to find new jobs when selling their home wasn’t an option because suddenly their houses were worth less than the mortgage.
The emergency fund’s primary purpose is to get you through an unexpected loss of income while causing as little long-term financial damage as possible. That’s why it’s also one of my personal financial ground rules. It’s also supposed to give you time to adjust to a new reality should you have a permanent change in income status, allowing you to keep paying your bills until you’re able to reduce them through cancellation or adjustment of service, sale of your home or termination of your lease, etc.
It’s NOT really intended to be what you tap for things like non-recurring but necessary expenses like home maintenance, new appliances, veterinarian bills, etc. Those should be worked into your everyday spending plan. The best emergency funds are those that are held in a separate account and remain untouched except in times of true emergencies. And once the emergency has passed, they are brought back up to their necessary amounts to protect against the next thing.
So what to do if you don’t have an emergency fund yet? First, you need to know how much you should be aiming for. If you don’t know what your monthly fixed expenses are, that’s a great place start. Our Expense Tracker tool is one way to figure that out, or you can use a free online tool such as Mint.com, which will link directly to your accounts and download your spending. That exercise can also help you figure out how much you can afford to save each month.
Then you just need to automate it by setting up a transfer to your separate savings account. Your payroll department may be able to even take money directly out of your check and deposit it directly. Otherwise, set the transfer for pay day so you never even have the temptation to spend the money. That’s what I do. (And yes, I’m still working to get my emergency fund fully set up, so don’t beat yourself up if this takes some time.)
Now don’t let the math freak you out. Six months of expenses is a big chunk of change! Start first by trying to get $1,000 in your account. I started mine with just $25 per paycheck!
After that, aim for three months worth of your mortgage or rent payment. Then tack on three months of car payments, then utilities, etc and if you have any little windfalls like a tax refund or you won the 50-50 drawing at your kid’s basketball game, use that to get you there sooner. Finally, it’s important to reassess the amount needed in your emergency fund when you have big life changes such as the birth of a child, new home purchase or even an empty nest when the amount needed may actually decrease.
The bottom line is, an emergency fund is your first line of financial defense against life’s little twists and turns. Even if you’re working to pay off credit card debt, it’s important to start your emergency fund to help you avoid derailing your debt pay-off plan should an unexpected expense arise. Don’t delay. Start saving today.