Most financial experts agree that the most important type of savings account to have is an emergency fund. In fact, your emergency fund should take precedence over any other savings, including retirement, college, or money earmarked for a down payment on a home.
The logic is simple: You never know when you might fall ill, lose your job, or encounter a situation where you've got bills to pay but have no money coming in. An emergency fund can protect you from undesirable consequences such as taking on high-interest debt, losing your home, or being forced into bankruptcy. The key, however, is to make sure you're saving adequately.
How much is enough?
Expert opinions vary as to how much you should aim to stash in your emergency fund. Conservative professionals might suggest stocking away enough to cover nine to 12 months' worth of expenses, while others feel that three to six months' worth is a perfectly safe bet. The amount you ultimately choose to save should depend on factors such as the number of dependents you have, your job-related prospects and qualifications, and whether you own property. If you're single and hold an advanced degree, you may feel comfortable saving just three months of expenses, but if you're married with three kids and a mortgage, you may want to aim for the higher end of that range.
Crunching the numbers
Once you determine your target savings goal, such as three months versus six months, you'll need to estimate your monthly expenses. Here are some of the things to include in your calculation:
- Rent or mortgage payment plus real estate taxes
- Homeowners or renters insurance
- Auto insurance
- Car payment
- Transportation costs, including gas, tolls, and bus or train passes for commuting
- Gas, electric, and water bills
- Home maintenance costs
- Cable, phone, and Internet fees
- Cell phone and data plan charges
- Medical costs, including insurance premiums, medications, and copays
- Toiletries and personal care items
- Childcare or preschool costs
- Clothing and other such necessities
- Miscellaneous expenses, including professional association fees or obligatory gifts and donations
Additionally, do yourself a favor and include a small amount of money to put toward leisure, like the occasional movie or outing. If you're ill or unemployed and therefore must resort to using your emergency cash, you'll want a pick-me-up here and there.
Why you need a buffer
While totaling your current monthly expenses will give you a good indication of how much you'll need in your emergency fund, remember that while certain costs may go down while you're unemployed, others could go up. Yes, you may not have to pay $200 for a monthly commuter rail pass, but on the flip side, you may spend more on gas and tolls driving to and from interviews. Similarly, while you may be able to temporarily eliminate luxuries like restaurant meals or a gym membership to keep your expenses to a minimum, you may find yourself spending a lot more money on health insurance, especially if your company subsidizes your premium costs. If, for example, your company currently pays a $500 monthly insurance premium for each of five members of your family, of which you contribute just $100 per covered individual, you'll be looking at paying $2,000 extra per month to remain on your plan.
This is why it's best to build in a buffer when calculating your emergency fund. You can do this in one of two ways: do your best to estimate those "what if" costs, such as the need to cover your health insurance premiums in their entirety, and add them to your monthly tally; or, come up with a lump sum that puts you at ease and add it to your total. That sum could be $2,000, $5,000, or $10,000. It all depends on your current and anticipated expenses, as well as your individual comfort level.
Once you've managed to save up enough money to fully fund your emergency account, you'll unfortunately be faced with yet another obstacle: the desire to use that money. Here's where willpower really comes into play. The point of an emergency fund is to have untouched, accessible cash on hand for when you really need it. As tempting as it may be to dip into that fund to buy new furniture, take a vacation, or give yourself more wiggle room during the holidays, your best bet is actually to pretend like that money isn't there.
In fact, think of that emergency account as an insurance policy of sorts. If all goes extraordinarily well, you can carry that money to the grave, leave it to your children or grandchildren as part of their inheritance, and thank your lucky stars that you never actually had to use it.