In this age when people are measuring everything from the number of steps they take, to how many hours they sleep, and even how many calories they burn while they are sleeping, it’s no wonder that people regularly ask me if what they are doing is considered “normal” when discussing their personal financial questions with me — we like knowing not only where we stand, but how we measure up compared to our peers.
But really, who am I to say what’s normal — is there even such a thing? This is why we have rules of thumb in the financial world. And while there are exceptions to all of the rules, they are generally good guidelines to help make decisions. One of the more common rules of thumb I discuss with people is the importance of establishing an emergency fund (often called a nest egg or rainy day fund).
How much should you have in your emergency fund?
Rule of thumb = three to six months of your expenses
While 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, this is a pretty good gauge of things to make sure you’re protected. 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 because 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.
What’s the emergency fund for?
Get you through an unexpected loss of income
The emergency fund’s primary purpose is to ensure you have the money you need to cover all your core financial expenses in the case that you or your spouse loses your job. Being unemployed is stressful enough, so it’s nice to know that you have that money aside, so that you don’t have to accumulate a mountain of credit card debt or miss payments that can impact your credit score. These savings will ensure this unfortunate event doesn’t cause too much long-term financial damage.
In the event that the loss of income is more permanent, it’ll also give you time to adjust to a new reality, 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.
Large unexpected one-time expenses
While this is more of a last resort, as you should be budgeting for most non-recurring expenses like home maintenance, pet illness, healthcare bills, etc., there are always things that come up that just can’t be planned for beyond just having the right insurance to minimize the impact. That said, it’s better to tap into these savings than it is to get into credit card debt that’ll amass large interest charges.
What it’s not there for
It’s NOT your piggy bank to tap into when you are feeling that spending itch or paying for expenses that should be planned for through your normal budgeting process like vacations, holidays, etc. This is your safety net and can leave you in pretty bad financial shape if you don’t have it when you need it (and you’ll need it, I promise). That’s why the best emergency funds are those that are held in a separate account that’s a bit harder to access and remains 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 do you do if you don’t have an emergency fund yet?
- Figure out your monthly fixed expenses: 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.
- Open a separate savings account: Trust me. You’ll want to keep it separate to make it harder to tap into. You’ll thank me later.
- Automate your savings: Set up a direct deposit or automatic monthly transfer to your separate savings account. Your payroll department may be able to even take money directly out of your check and deposit it for you. 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 on that scratch ticket your friends got you for your birthday, 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.