Emergency Funds
Updated: Aug 4, 2020
In the past few years, has your car broken down or needed new tires? Maybe you had medical bills that amounted to a substantial sum? Has that cute new puppy gotten sick and gone to the vet? Did you need repairs for a broken appliance? Or have you ever been woken up at 3:00 am by a torrential rainstorm that ends up violently tearing some siding off your house? Oh, wait–maybe that last example just happened to me…
If you are like the majority of Americans, you would not have enough money built up in checking/savings accounts to cover those unexpected costs. According to Bankrate’s recent survey, 63% of Americans said they could not afford an emergency expense of $1,000 from their checking or savings account. $1,000 worth of emergency funds may be enough for one unexpected cost but when discussing losing a job, it is not enough.
Many clients have questions about an adequate amount of emergency funds. Many have a preconceived notion that this is a fixed amount like $10,000, $20,000, $30,000, etc…
However, a more appropriate way to calculate emergency funds is based on monthly non-discretionary expenses. Before we look at how many months of non discretionary expenses we need, let’s dive into the difference between discretionary and non-discretionary. Discretionary expenses are non-essential items for living or can be considered “luxury”. Some examples are entertainment, travel, hobbies, dinning out, etc. Non-discretionary items are then the exact opposite or items that are essential to living, like food, shelter (rent/mortgage), utilities, debt payments, gas, or other bills.
Non-discretionary expenses are used in calculating an appropriate level of emergency funds because they cover the essentials. If a job is lost, a few hundred dollars do not need to be spent on entertainment monthly like it does on food or shelter.
For an example, Johnny and Suzanne total up their monthly non-discretionary expenses (necessary expenditures) and they equal $3,000. Their three month emergency funds would be $9,000 (3 months times $3,000) and 6 months would be $18,000 (6 months times $3,000).
Like many other items in financial planning, there is not a one size fits all answer for the number of months of non-discretionary expenses needed, but the general rule of thumb is 3 – 6 months. The factors that help to determine if you need to save for 3 months, 6 months, or somewhere in the middle include:
One vs. two income household
Job security
Likelihood of obtaining a new job
Risk tolerance
If you are unsure or do not have 3 – 6 months saved in emergency funds, don’t panic! Below are steps to get on track:
Calculate your monthly non-discretionary expenses.
Determine how many months (3, 4, 5, 6 or more) you feel comfortable with having in a savings account for emergency funds.
If currently there is a shortage in your savings account compared to your goal, set up a plan to reach your goal.
Some ideas on helping to achieve your emergency funds goal could include:
Cut back on expenses and divert money into savings.
Put a percentage of your paycheck into your savings before you spend it.
If paid 26 times a year, during the months there are three paychecks, put the third paycheck directly into savings.
Put your tax refund into your savings.
The vast majority of Americans do not have adequate emergency funds. Like every financial concept, emergency fund amounts can vary from person to person and will fluctuate over the years. Emergency funds can reduce the risk of or completely eliminate financial disasters that can take a decade or longer to recover from. Feel free to reach out for more information or with questions.
Evan@EWwealth.com
Work: 317-587-0858
Cell: 317-627-2529
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