Most of us are familiar with the idea of stashing away cash for times of need, though not all of us actually do it. Of those of us who do, our habits vary a lot. Some only have a couple hundred stashed away, while others may be saving too much and not living enough. Pretty much all financial experts agree, though: we need a rainy day fund. Sooner or later, some expense is going to come up that we don’t expect, and if we have to put it on a credit card, it’s going to end up costing us a lot more.
So on to the obvious question. How much do I really need? Most financial advisors recommend between three and eight months of expenses, with the risk takers leaning toward three months, and the more conservative experts recommending eight (I’m looking at you, Suze Orman). There are a few steps you have to take before attaching a dollar amount to this recommendation.
Before you even decide how conservative or risky you want to be, you have to know what your expenses are. If you pay all of your bills from the same checking account, this will be easy to track by looking at your monthly statement. If you have several accounts, you might want to use a program like www.Mint.com to calculate your monthly expenses. Add all of your accounts, and it will do the work for you. Whichever method you choose, for a good estimate, average your last three months of expenses.
Don’t include the money you put toward savings or retirement, although you can include credit card payments if you plan on saving up your emergency fund before paying them off (I discuss your choices below). Include things like eating out and trips to the movies. It is best to cut back on these if you’re in a pinch, but even if you lose your job, you still need to have fun sometimes.
Once you’ve figured out what your average expenses are, it’s time to decide how many months of no income you want to buffer yourself against. If you have a stable job such as a tenured teaching position, you’ll probably be safe with three. This is especially true if you have a spouse who also works, since it’s less likely that both of you will lose your job at once. If you’re a freelancer, or work in a field such as construction, you’ll want to save up at least six months’ worth in case you can’t find much (or any) work.
If you have a safe job but want to be prepared, you can always save a little bit extra, but there is such a thing as going too far. If you have over a year’s worth of expenses set aside in a savings account (unless you are already retired or about to retire), you’re giving up interest you could be earning. Even a CD would earn you more interest, although if you’re in this position, you probably need to be contributing more to your retirement account.
Now that you have that figured out, there’s another question to consider. When do you save up your emergency fund? If you’re in debt, you may be wondering if you should pay off your credit cards before you set aside thousands of dollars earning only around 1%. There are differing opinions on this, but my favorite is to save up a small emergency fund (say, $1000) before your debt is paid off, then after paying off all non-mortgage debt, continue saving until you reach your full emergency fund. This plan assumes that you are trying to pay off your credit cards. If you’re not, you should still have an emergency fund. Your strategy would be to skip right to saving up the full three to eight months’ worth.
Now that you have a clearer idea of how much to save, preparing yourself for unexpected expenses should be much easier. A proper emergency fund can solve a lot of your financial problems. When you have the money set aside for the unexpected, surprise flat tires are no longer a big deal. Losing your job is no longer a traumatic event, but a chance to start over. If you don’t already have an emergency fund, or yours needs a few tweaks, head on over to your money-tracking website of choice and get started today.