In times of crisis, you don't want to be shaking pennies out of a piggy bank. Having a financial safety net in place can ensure that you're protected when a financial emergency arises. Your emergency fund is a pool of readily available funds that can help you handle emergencies or highly urgent short-term needs.
How much emergency fund is enough?
Most financial professionals suggest that you have at least three months' worth of living expenses in your cash reserve. The actual amount, however, should be based on your circumstances. Do you have a mortgage? Do you have short-term and long-term disability protection? Other similar factors to consider include your job security, health, and income potential. The bottom line: without an emergency fund, a period of crisis (e.g., unemployment, disability) could be financially devastating for anyone.
How do I calculate three months’ worth of expenses?
You may want to consider creating a budget to help you understand your spending habits and expenses. If you don’t have time for that now, you can begin with looking at three months’ worth of expenses to calculate your emergency fund.
Calculating your expenses isn’t rocket science – all it requires is your time and an honest outlook. Take the time to add up what your expenses are over a typical three-month period. If you currently have a car payment or are in the midst of paying for a child’s braces, include those expenses. If you’re saving up in the short term for a trip that’s coming up next month, don’t include that – it’s not a typical expense.
Be willing to cut out unnecessary expenses when calculating what you need to save – but be honest about what you would continue to spend as well. If you really value getting coffee on Saturday mornings or eating out a few times a month with friends, include those expenses in your calculation.
How do I build my cash reserve?
If you haven't established a cash reserve and begun saving for an emergency, or if the one you have is inadequate, you can take several steps to eliminate the shortfall:
- Use earning from other investments (e.g., savings accounts, dividend-paying mutual funds or stocks)
- Reduce your discretionary spending (e.g., eating out, movies, spa days)
- Save aggressively — if available, use payroll deduction at work; budget your savings as part of regular household expenses
For your fund, you should only use current or liquid assets (those that are cash or are convertible to cash within a year, such as short-term certificate of deposit). Don’t consider assets like vehicles or property in calculating your emergency fund.
Also keep in mind that a credit line could be a secondary source of funds in a time of crisis – especially if you’re not able to save up three months’ worth of expenses right now. But beware that borrowed money must be paid back (often at high interest rates). As a result, you shouldn't consider credit lines as a primary source for your emergency fund.
Source: Broadridge Financial Solutions, accessed July 31, 2019.