This is the next article in my ‘Back to Basics’ series. You can read my first article, on compounding interest or my follow up article on predatory lending This article is meant for everyone. If you’re a junior enlisted person or junior officer, please share this with a friend. If you’re a leader of junior troops, feel free to use this article as a set of talking points for your one-on-one sessions. The focus of this article is to help you understand how much you need in your emergency fund.
This article was first generated in the form of a handout by my friend and instructor, Robert Reed, of Partnership Financial LLC, in Columbus, Ohio. I have tailored some of the content for educating our military readers who might benefit from this advice. Thank you, Rob for everything.
When dealing with money, the most important question is: “How much money do I need in my emergency fund to deal with the unexpected?” If you can honestly answer this question and put this amount of money aside to address issues that come up, then the rest of your money should be put to work in low cost, tax-advantaged investments that will grow over time.
How do I know what’s an emergency & what’s not an emergency?
What’s not an emergency? Living above your means is not an emergency. Take a look at your last 3 months’ of bank statements. If you’re spending more money than you make, write down the top five things you’re spending your money on. If that list consists of things like clothes, food, mortgage—all things that should be budgeted, then that’s not an emergency. You are probably living above your means, and need to establish a budget before you can determine how much cash to set aside for emergencies.
Emergency: A one-time, immediate, unanticipated expense. This definition covers a very wide range, from minor car repairs to living expenses after a sudden layoff. Since there are so many ways in which life can trip you up, it might be better to break this up into ordinary and extraordinary emergencies.
Ordinary Emergencies are those irritating life moments that suddenly pop up because but you thought you’d get to them, eventually. Think of emergent car and house repairs, an emergency room bill, or airfare to fly to a wedding or funeral. Your ordinary emergency fund should consist of cash that’s available in a savings account. Do not substitute home equity or credit cards for cash, this will bite you in the end! Use the cash as you need it, then replenish that cash as soon as possible.
How much should I have in my emergency fund?
How much cash you need for ordinary emergencies depends on how stable your income is.
-If you have a stable job and regular income, then set aside 10% of your annual income.
-If you have your own business or if your monthly income is variable (for example, based upon commissions or seasonal income), then set aside 20% of your annual income.
-If you are retired, then set aside 30% of your annual expenses (not income).
Extraordinary Emergencies are events we don’t want to think about because they are life-changing moments. Think about the sudden loss of an immediate family member, a life-threatening disease, or losing your job. Extraordinary emergencies will make you stop in your tracks.
Money should not be the first consideration when dealing with an extraordinary emergency. It is about support. It is about supporting a loved one though a difficult illness. It is about supporting your family while you’re suddenly unemployed and as you search for a new job. The only certainty about a dire emergency is that you will have much less income. It’s hard to tell how long this will last, but your dire emergency fund should be enough to help you ride out the situation or make those major adjustments that you need to make.
To address an extraordinary emergency, you should have 20% of your mortgage balance or twice your regular emergency fund—whichever is more. Having this money set aside will allow you to keep your home as you work through your more significant concerns. An adequate extraordinary emergency fund should allow you to pay your housing expenses for 2 to 3 years.
Your Extraordinary Emergency fund will be a large number and can be difficult to envision. You should expect to save this much money over time. Also, if you’ve been setting money aside in retirement or other accounts, you may find that you already have enough money set aside. In that case, you would just need to make sure that it’s available when you need it.
The important thing to remember about your Regular and Extraordinary Emergency funds is that this money is not put aside to grow. This money is saved to address life’s emergencies and to help provide financial stability when you need it.
As always, this blog serves to answer your questions and address concerns. If you like this blog, please forward it on to other people who may benefit. If you have issues or concerns, or if you have a question you’d like me to answer, please feel free to contact me. You can reach me through my website, or via email. In the meanwhile, take charge of your life!