How Much Do I Need in the Emergency fund? - Bro
The purpose of an emergency fund is to have some cash available in case something unexpected happens. Something unexpected could be losing a job, having a car break, or losing your phone. An emergency fund should not be touched for things that are not emergencies. Things that are not emergencies are christmas, routine auto maintenance, or any other bill that can be anticipated. With this in mind we can now think about how much we need for our emergency fund. When measuring the size of an emergency fund instead of thinking in dollars needed, I think about how many months of expenses I need. For example if I need $3,000 a month to keep the lights on and pay the mortgage (if you have one) then 6 months of emergency savings would equal $18,000.
The best way to approach the idea of an emergency fund is to honestly think about what emergencies are likely to come up, how hard they will hit you in the wallet, and how likely can you just pay for it out of your day to day cash flow. Losing a job might be fairly uncommon depending on your job, will hit the wallet hard, and is difficult to pay out of cash flow. Losing a phone is fairly common but won’t hit the wallet hard and can be paid for out of cash flow.
How likely something is to come up is the most important thing to think about because as humans we have a tendency to think of worst case situations. If we don’t keep perspective then we will end up trying to prepare for every single possible problem. It is not likely that the stock market will crash to zero so we do not need to hoard gold in our emergency fund. It is likely that at some point in our lives we will have to take a significant pay cut or lose our jobs. If you are a homeowner it is a certainty that your water heater will fail eventually. The more likely something the more we need to prepare for it.
The damage an event does to your wallet is the next most important factor to your emergency fund. Something small like losing your phone is not going to hit you too hard. A medical emergency could get quite expensive depending on your insurance situation. The bigger you think the possible events are the more savings you need.
Cash flow has many definitions but in this context I define cash flow to be the amount of money you have available in your day to day budget that is not required for standard living expenses. Standard living expenses are basic groceries, electricity, and gas for your car. Money that would be included in cash flow would be items that are discretionary like eating out, going to the movies, investments, and donations. If you were to have an emergency you could cut back on your eating out and delay your donations until everything had settled down. A car repair might cost you a few hundred dollars but if you typically invest a thousand dollars a month you can easily put off your investments and get your car fixed.
With these 3 factors in mind, for my situation 6 months of emergency funds is ideal (A.K.A $18,000 if my expenses are $3,000 a month). The most expensive thing that I would worry about would be job loss. If I were to lose my job my wife or myself could find a job that would pay the bills in 6 months or less. One factor with job loss is the fact you only need expenses one month at a time. I get about 1 month's expenses in dividends every year. A portion of this is paid every 3 months so every so often I get a decent chunk of change. In addition we have a low cost of living so if we needed to we could really cut down on spending. Another major expense would be a significant home repair or car repair. Both of these possible events should be under the 6 months of expenses.
Last, it is important to not oversize your emergency fund especially while you are still trying to grow your nest egg. Every dollar you have in conservative savings (where most of your emergency funds should be) is a dollar that is not out there earning you real money. Don’t let an emergency derail your goals but don’t let fear slow you down. In the next articles I will discuss where to put your money and what kind of return to expect. In addition I will discuss some alternative (riskier) methods you can use if you want to push for FI sooner.