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$1000 emergency fund? 6 months expenses? 1 year salary? Throw them all out the window!

When I first started getting serious about having our financial house in order, the first piece of advice I got from all the experts was – have an emergency fund. OK, got it, I will work on that! Umm… but how much should I have? No idea. The advice I got ranged from $1000 baby emergency fund to 1 year salary. That is a pretty wide margin to choose from.

How much should I really have? Is there anything called saving too much for an emergency fund? What are the assumptions under these “X” month’s salary advice?  I was confused. So I decided to throw all the rules out the window and make my own set of rules on how much emergency fund I should have. During the course of the last 4 years my emergency fund evolved from a baby emergency fund to much more as we started getting financially disciplined.

How much emergency fund do I need? – Baby emergency fund

First of all, when starting out, we just started adding $50 to emergency fund every month, because if we waited to do the whole calculation and try to figure out the perfect amount, we would have kept waiting. No, we wanted to start… with whatever we could. We targeted $1000 as a first milestone.  We sold whatever we didn’t need and made it sort of a game to find things to sell :) We hit the $1000 milestone and wanted to figure out how much emergency fund we would ideally like to set aside – as a short – medium term goal.

This is where we hit a snag. You see, my husband is an optimist and I am a pessimist.

How much emergency fund do I need? – For the Optimist

how much emergency fund do I need for the optimist

My husband wanted to save one month’s living expenses and be done with it. I found all sorts of problems with this, but we had to start somewhere, so after our baby emergency fund, 1 month living expenses seemed like a good goal to have.

We started figuring out what our one month’s living expenses would be. We could have just taken our spending plan and saved that much, but if we are only saving one month’s living expenses I wanted to include expenses that will change when we have to really touch the emergency fund.

If I lost my job, I won’t need to do dry cleaning and we definitely won’t eat out as frequently as we do when we are both working. So those expenses can go. And some expenses go up. When I was looking for a job, my phone bill went through the roof. I need a job, so that is not the time to cut on phone bills.  Excel to the rescue! I took our spending plan and marked each category as (1) Stay the same (2) Will go up (3) Will go down.

This needs careful consideration. Some people might think they can just cut out child care if they lost their job, but will you be able to make it to the interviews without child care? Go through your budget item by item and check which ones you will still need and which ones needadjusting. When you are done with this step you will have something like this –

Emergency Fund Budget

I now had my target amount and the target date I wanted to have this goal accomplished. I opened a separate Ally bank subaccount and direct deposited the required fraction every month.

How much emergency fund do I need ? For the pessimist

Around this time came the great recession. One of my friends lost his job. It took him 5 months to find a job. Now the pessimist in me was really awoken and cursing me for not saving more. I sat down again with all our expenses and did more calculations. This time I considered a few more issues:

  1. Job security/Number of months I expect to be unemployed
  2. Possible emergencies
  3. My personal situation.

Job Security & Unemployment period

There are a few things that would have made it difficult for us to find another job immediately. Both of us are in a specialized occupation, so it is not very easy to get another job. Specialized occupation also means, above average pay. In all probability we might have to take a lower paid job than the current one. So longer time without pay and even longer time with a pay cut. We can’t expect any severance and due to our personal situation, we won’t apply for unemployment either.

On the plus side, we are not in the same field, so we “might” not get laid off at the same time. But we never know. I looked at the job postings and based on our prior experience and the time it took some of our friends in the same field to find a job, I came up with a potential unemployed time – 3 months.

# of months I expect to be unemployed : 4 3 (Previously, I had incorrectly shown the number of months I expect to be unemployed as 4, when, instead, I had used the number 3 in my calculations.  I have fixed this error now.  A big thanks to Amber for pointing out the error.)

How much emergency fund do I need considering my job security : Amount needed for one month X expected # of unemployed months -> $1390 X  3 = 4170; so I will absolutely need ~$4200 to feel safe.

Possible Emergencies

I would like to plan for every single emergency in the world, occurring at the same time, because I am a firm believer in Murphy’s law. The logical me knows that would be stupid, but we did consider some emergencies together. For example, Job loss + accident; Job loss + health problems. Nothing major but at least one major and a minor emergency put together. These are the expenses we considered –

  1. Car Insurance deductible $500
  2. Health Insurance Premium in case of job loss (COBRA) $400 X 6 (peace of mind time frame)
  3. Health Insurance Copay for 3 doctor visits $60
  4. Cushion for other expenses $300
  5. Total : ~$3500 for Murphy

Considering my personal situation

Every family is different and could have situations that cannot be accounted for in the general emergency fund advice. But that doesn’t mean we can ignore the personal situation right? For us, it was a trip to our home country in case we needed to make a quick trip to help the parents.

2 RT tickets (bought in a short time frame, which means we can’t hunt for deals) : $4000 (yes, it is that expensive)

We are also a two income household, so we could have some breathing room even if one of us gets laid off. So our situation is different from a single income household. If you are single, that is a totally different situation than if you are married. The stakes are even higher if you have kids. If you/anyone in your family have any special medical conditions that require a good amount of money every month, please don’t rely on any rule of thumb. Are there any expenses that will be unique to you? Do you own calculation.

So for us the “ideal” emergency fund was : Monthly expenses X “peace of mind time frame” +Murphy money + 2RT tickets to our home country = ~$16000 

Too much? May be. But that will help me sleep peacefully at night so it is worth it. Finally, I plan on doing this calculation every time there is a major life change – New house ( to make sure I factor in the mortgage and all the expenses that come with it, and may be add in an extra house maintenance money) or when we have a baby.
I personally think it is a good idea to recalculate the bare minimum at least once in 2 years. Your expenses might have changed in those two years. You don’t want to be in a situation where you “think” you have saved up 6 months of expenses only to find out you have just 2 months when you really need to use it!

Now we don’t have the entire thing saved up. I would like to know the amount I am aiming for to keep me on course. As we are already past the baby emergency fund and the one month expenses, we are slowly trying to save to hit the ideal emergency fund amount.

 

Where we have our emergency fund parked

I realize that deciding to have a large amount of emergency fund, I am trading the opportunity for it to grow. So we have our emergency fund in different levels of liquidity. We have a couple of hundred dollars in cash, a few more hundred in a checking account that we could take out as long as the ATMs are working. The rest of it, we have it in a Ally Bank Sub account (check out the Online Savings page for current interest rates of various online savings accounts). You can also have this in a rewards checking account or other high interest savings account like American Express or Capital One 360.

Recently we decided to up our emergency fund to 8 months expenses for personal reasons. Instead of keeping this in a savings account, I decided to open a ROTH IRA to keep our additional emergency fund. Hopefully, we won’t have to touch this and it will be waiting for us when we retire, but if needed it is there to keep us afloat during those rainy days.

So personally for us, it has not been one rule of thumb. It has evolved and been tweaked to match our risk tolerance. I have attached a spreadsheet to do a similar calculation. The first column of the sheet has all possible expenses, you can remove the expenses that are not in your regular budget/spending plan. Enter the regular amount you spend in the second column as per your budget, the third column is the adjusted budget, in the fourth column fill in the additional personal situation amounts. It should give you the different recommendations.

Now I would like to know how you have approached your emergency fund. Do you have a fixed amount or x number of months’ worth of expenses? Do you also have cushion for other contingencies? Or just bare minimum of expenses?

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