How much do I need in an emergency fund?

by David Berky

Downsizing, rightsizing, forced retirement, layoffs, firings, outsourcing, and being made redundant.

All could mean the same thing to you: financial catastrophe.

No, you may not have to declare bankruptcy or move back in with your parents, but losing your job could put a big dent in your financial goals and even set you back several years. You may need to live on your savings or liquidate some of your investments.

If you have no savings or investments you may have to rely on credit cards and could rack up significant credit card debt. Then when you find a new job, your expenses may have increased because of the additional credit card payments.

And the job you eventually find may not pay as much as the one you lost. So you are now forced to live on less while your expenses have either continued at the same level or even gone up.

Studies show that the average worker will have six career changes in his or her lifetime. Not just job changes, but career changes.

So how can you prepare for your own financial "downtime"?

An emergency fund.

An emergency fund is really just savings. But it is not savings for a particular item or even an investment for your future or your retirement. It is your "rainy-day" fund. But unlike insurance where once you pay your premium, the money is out of your hands, your emergency fund is yours to keep.

So how much do you need? How can you build your emergency fund? And where should you keep the money?

The easiest way to figure out how large your emergency fund should be is to take your current income and multiply it by the number of months you could be out of work. If you make $3,000 each month and you want to be prepared for a 6 month "vacation", you will need $18,000.

But obviously saving $18,000 will take some time. How quickly you want to build your emergency fund depends on how concerned you may be about your current and future employment prospects.

Saving $100 each month will take you 180 months or 15 years. Saving more each month means you will be protected sooner. Also consider that during the next 15 years your income may increase and your expenses usually rise to match your income.

Also consider inflation. (If you own your home, your house payment may not rise. If you are renting, your rent probably will.) The cost of food, utilities and taxes also rise over the years. At a 3% inflation rate after 15 years your $18,000 will only buy $11,400 worth of goods.

A good rule of thumb for saving is to try to save enough each year to supply you with one month's income. This means you are saving 1/12 or 8.3% of your monthly income.

This will allow you to build your emergency fund by one month every year. After only six years you will have a six-month supply of emergency cash. Then you can continue to extend your "coverage-period" or you can divert the monthly payment into other savings or investments.

Most people find that "billing" themselves for savings and investments is a good way to put your savings on auto-pilot. If an amount is taken automatically from your bank account each month, it is easier to handle than if you wait until the end of the month and try to save from what you have left over. (How often do you have anything left over?)

So where is the best place to keep your emergency fund? Probably not a place where you can have easy access to it - too tempting. Definitely not as cash in the cookie jar - too unsafe (and no interest). And probably not in 5 year CDs - too restrictive. You may want to avoid CDs altogether so that you are not charged an early withdrawal penalty when you can least afford it.

Savings accounts are OK, but usually pay very little interest. If a savings account is your choice, open one at a bank that you don't regularly use. Also don't get a checking account to avoid the temptation to spend "just a little" bit here and there.

Or look for a money market account that pays a reasonable interest rate. You may want to consider a money market account that only invests in tax-free securities. This way you won't have to worry about paying taxes on your interest.

Then set up an auto-withdrawal from your regular checking account or direct deposit amount from your pay check right into this new account. Adjust your budget to accommodate having less money each month and forget about it.

You can also give your emergency fund a boost now and then by putting "windfall" money into to it. You know "free-money"; birthday gifts, inheritances, insurance settlements, escrow overages, rebates, tax refunds, etc.

Your emergency fund becomes your own financial insurance policy. And if you never use it you will have that much more money to play with when you retire. Or even retire early with the extra money you have saved.

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© Simple Joe, Inc.
David Berky is president of Simple Joe, Inc. a marketing company that sells simple software under the brand name of Simple Joe. One of Simple Joe's best selling products is Simple Joe's Money Tools - a collection of 14 personal finance and investment calculators. This article may be freely distributed so long as the copyright, author's information and an active link (where possible) are included.