emergency fund » The Art of Money

How to Calculate the Size of your Emergency Fund

Nov 122011

Some people like to proscribe the specific amounts of money people should have in their emergency fund. You should have $1,000, 3-6 months expenses, I’ve even heard that you need 2 years of living expenses socked away!

What these overly dictatorial suggestions miss is that the size of your emergency fund will depend on the uniqueness of your situation.

Let’s take two people, Jack and Jill, to illustrate what I mean.

Jack
Jack is a 24-year old recent college graduate working as a video game designer for a top firm in LA. Jack lives on Hot Pockets and Ramen noodles, and treats himself to the occasional Lean Cuisine. Jack’s hobbies are playing video games and tooling around on his Mac, downloading free songs. Jack has low monthly expenses; he only needs a minimum of $2,000 per month to survive. The video game industry is growing rapidly, and he and his friends all got jobs right out of college. A couple of his peers even waited for a month to weigh job offers against each other. Further, in the past 2 years that he’s worked at his firm, no one has gotten fired; in fact the company has been hiring like crazy to keep up with demand. Most of the senior executives have been there for 5, 10 and 15 years.

Jill
Jill is a 42-year old investment banker and mother of 3 children. She works for a mid-size bank in NYC. Jill and her husband have grown accustomed to the fine dining available in the Big Apple. They have a mortgage on a new house, two car payments and are financing their oldest son’s college education. Jill needs a minimum of $6,000 per month to survive. There has been turmoil in the financial services industry, and people are getting fired left and right. Several of her coworkers who have been let go have been searching for jobs for more than 6 months; some have left the finance industry completely because no one is hiring. Many of the senior executives have been let go.

What would be the ideal size of the emergency funds of Jack and Jill? Obviously, they would be vastly different.

For Jack, the likeliness of getting fired is relatively low. The video game industry is growing, and talented designers are not on the job market for long. Even if he did get fired, due to his low-cost interests, it wouldn’t be a terribly expensive event. Jack might want an emergency fund that’s sufficient to cover 2.5 months of job searching.

Jack’s Emergency Fund: $5,000

For Jill, the likeliness of getting fired is relatively high. The financial industry is laying people off, and it takes a long time to get a new job. The cost of getting laid off is higher for Jill, because she owns a home and has a family to support. Jill might want an emergency fund that covers 7 months of job searching.

Jill’s Emergency Fund: $42,000

How big should your emergency fund be? What factors should you consider when determining its size? Please share in the comments!

The 3 Things You Need to Know About Emergency Funds

saving No Responses »

Nov 032011

I’m going to go ahead and make a bold statement here: everyone should have an emergency fund.

What do I mean by an emergency fund? I define an emergency fund as a zero interest, liquid asset that will get you through expensive, one-time events that are likely to occur. Usually, this means cold, hard cash.

The fact of the matter is that we live in an uncertain world, and we never know what may befall us in the future. We may lose our job and need to cover our expenses without a salary. We may need an emergency medical procedure that isn’t fully covered by insurance. A close family member may need a loan. Our best friend may need to be bailed out of jail. Depending on your situation, there are innumerable things that can happen, and it behooves us to have an emergency fund that we can draw on to avoid financial disaster.

There are several attributes that I use to describe an emergency fund, so let me break them down one-by-one.

Zero interest. This means your emergency fund SHOULD NOT be a credit card. Having a credit card that charges 14.99% interest if you don’t pay off the balance is a very expensive emergency fund, and will likely worsen your financial predicament. Zero interest means cash that you can draw on where you don’t have to pay any interest on the money. Even better, your emergency fund will be earning interest, as I do with my ING Direct Orange Savings Account.

Liquid. You must be able to draw upon your emergency fund as you need it. If you lose your job and need to buy groceries, trying to sell your rare coin collection will probably mean you go hungry. Again, this usually means cash, but could also include financial instruments like a CD ladder.

One-Time, Expensive, and Likely. I know, these are three attributes packed into one, but they’re all related in that they will determine the size of your emergency fund. For example, if we’re building an emergency fund to tide us over until we find a new job, we will need to know roughly 3 things:

our bare-bone monthly expenses
the median amount of time it takes professionals in your industry and geographic area to find a new job
how likely it is that lay-offs will occur at your company.

In a future blog post, I’ll use two hypothetical situations to show you how to calculate the size of your emergency fund. For now, I just want to introduce you to the 3 things you need to consider when building one.

Do you have an emergency fund? If so, is it zero interest, liquid and enough to cover one-time, expensive and likely events? Please share in the comments below!