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Reader Question Regarding Emergency Funds
By JLP | February 17, 2009
I received the following email this morning from an AFM reader:
Hello,
I read your blog (and a few other financial blogs) mostly every day. I read a lot about the importance of keeping a liquid emergency fund for about 6-months worth of expenses. What I have not heard however, is what basis that 6-months is calculated on.
1) Do you include any employment insurance benefits as a reduction in the amount required?
2) Do you use your regular expenses as a guide for spending? Or can you take credit for some reduction in discretionary spending?Just looking for some opinions / guidance as I’m fairly new out of university and think it is important to have some level of financial stability. Thanks!
Brandon
First off, the “rule of thumb” is three to six months of living expenses. Where and how they came up with that number I’m not sure.
1) Do you include any employment insurance benefits as a reduction in the amount required?
As far as I can tell, the “rule of thumb” does not take into account unemployment benefits. So, unemployment benefits would reduce the amount necessary in your emergency fund. However, keep in mind that in addition to providing your day-to-day income needs, your emergency fund will also need to provide a cushion for unexpected needs that will pop up (car repairs, plumbing problems,…). So, I would look at unemployment benefits as just that: a benefit.
2) Do you use your regular expenses as a guide for spending? Or can you take credit for some reduction in discretionary spending?
During a period of unemployment, you would be advised to cut out all unnecessary expenses. Afterall, you don’t know how long you’re going to be unemployed. Plan your emergency fund need on a reasonable budget to give yourself some leeway during a period of unemployment. Some needs will be reduced while others may pop up. For example, you may need to buy a new suit (if you don’t already own one) in order to go on job interviews.
I think the main thing to keep in mind when it comes to emergency funds is to HAVE ONE! Too many people have nothing set aside and have nothing to fall back on in times of need.
One last thing: I would avoid using credit cards if at all possible. Charging up your credit cards and then not being able to pay them back would be devastating to your financial situation as well as your credit score.
Topics: Budgeting | 14 Comments »
February 17th, 2009 at 10:54 am
You’re right – the most important thing about an emergency fund is just to have one.
Granted I’m just starting my fund, but here’s what I’m doing.
I don’t account for any unemployment benefits.
And right now, I’m only planning for actual expenses (like bills, rent, etc…), but once I start hitting my goal of 6-8 months of expenses saved, I’ll definitely expand it to include some discretionary spending too.
I also think that you shouldn’t rely on credit cards in a pinch. They may help you with a short term emergency, but you’re still going to be left with a big bill down the road. And if you don’t have the cash to pay for expenses, how will you be able to pay those CC bills when they come due?
February 17th, 2009 at 11:28 am
For my (brand new and very small) emergency fund, I am not planning on receiving any outside assistance (like unemployment).
Right now, I’m only saving for actual expenses, not discretionary spending. But once I reach my 6-8 month goal of expenses, I’m going to include some extra for discretionary.
February 17th, 2009 at 11:33 am
I’m just starting an emergency fund, and here’s what I’m doing to make it a priority that sticks.
1) Don’t plan on receiving any outside assistance
2) At first, just save for actual expenses. Once you hit your 6-8 month reserve, then work on expanding it to include discretionary spending. No need to complicate things at first.
3) Contribute to it as soon as you get paid.
4) Increase the amount you contribute gradually each paycheck. By starting small, you get used to it, so it’s more likely to be a permenant change.
5) Contribute to it whenever you have money leftover from smaller than expected bills, or if you have money left in your account when you get paid.
February 17th, 2009 at 12:30 pm
The three to six months’ worth of expenses is a guideline, and it is certainly vague. The guideline is not meant specifically to sustain your for a set period of time if you lose your job. It just tends to work out that roughly the same amount of money can handle most common emergencies including interruption of income.
Ultimately, your individual lifestyle, exposure and likelihood to emergencies, and the potential cost of such emergencies should dictate the size of your emergency reserve. It’s an unknown, and there is no right or wrong way to pick a reasonable target number.
I you need a non-vague target to get you started, I suggest an amount equal to 20 weeks worth of your net (after-tax), household take home pay. (If you get paid every other week, just multiply your net times 10.) That’s roughly 4.5 months of regular spending.
Start with that number and adjust it up or down based or your own unique set of circumstances. If you lose your job, you will probably decide to cut unnecessary expenses so you can pay for health insurance or whatever or stretch out the money as long as possible.
February 17th, 2009 at 1:01 pm
Regular expenses, this is too nebulous. Maybe its just me, but subsidies from my employer for items such as healthcare, will take a big bite out of my emergency fund. And I only just realized this, so call me stupid. Along with known expenses, I’d recommend you research anything your employer paid for or subsidized, COBRA is not cheap. I’ve just seen my fund that I thought was good for one year go to 7 months.
February 17th, 2009 at 2:40 pm
I’ll echo some of the other comments by saying that it all depends on your personal circumstances. The 6-month rule of thumb came from some person’s estimation of how long it would take to find another job if you lost your current one.
If you work in a job where you are more likely to be laid off, or laid off more often than the average person, then you would need to up the amount in your emergency savings. If your line of work is such that it takes longer to find another equivalent position or you would be more likely to have to move somewhere else to get an equivalent position, then you would probably need more money in savings.
Likewise, if you are married and your spouse is in a more secure job or carries the health insurance, your need for savings may be less. Another possibility is that you are nearing retirement and could take an early out with no big impact to your finances. The whole point is not to stick with some predetermined number or percentage, but to take some time to figure out what you would need to live on until you could find another job.
And a fair amount of pessimism may be in order. If both husband and wife could get laid off at the same time (because you both work for the same company for instance), then you may want to figure it into your calculations.
February 17th, 2009 at 5:10 pm
Don’t count on unemployment when figuring your emergency fund. Many people are fighting for unemployment money that is rightfully due to them. I happen to know one personally.
Also, 6 months may not be enough these days. If you can save more, do so. 8 months sounds better to me, but really it depends on how hard it will be to find another job that meets YOUR needs. That depends on what sort of work you can do, how much you need to make, if you can move, etc.
While you should plan to cut back expenses if you find yourself unemployed, take into account that you may actually have more expenses like job hunting expenses, moving expenses, paying for life insurance out of pocket, and losing any other employee discounts or reimbursements! Plus, human nature what it is, we aren’t usually our best about cutting back on wants when we’re stressed. After a long day of discouraging job hunting, are you always going to super frugal or are you going to say “Screw it!” and go join your friends for a night out.
February 17th, 2009 at 7:43 pm
I agree with everyone’s comments about “regular expenses” being a red herring. From my personal situation, my wife is unemployed and they’re challenging her right to benefits, we just had a kid and there were issues with insurance covering some of the bills, there were just layoffs at the day job and that’s spooked everybody.
Last year I thought I had a very conservative 2 years cushion, now I’m not so certain. As Amsalp says, COBRA ain’t cheap. I guess what I’m saying is that you want to have as much reserve as you can get, and not rely on things like unemployment to hold you over.
February 17th, 2009 at 9:50 pm
Per my CFP classes the 6 month figure is not only to accommodate a job search that would last that long, but also to provide funds before any short-term/long-term disability payments would commence (given many have a 180-day waiting period).
RE: excluding the unemployment comp. Better to be conservative and pleasantly surprised that you have enough in your E-fund than vice-versa.
Also, unfortunately, unemployment benefits are taxable income and normally taxes are not withheld. You’d then owe more on your tax return unless you were overwithheld from your prior employment withholding OR your 6.2% FICA started over w/Employer #2 and you ended up paying in more than the annual cap and would thus apply it to taxes paid in. Clear as mud?
So there is no free lunch once again, (unless you’re taking TARP money that is!)
February 17th, 2009 at 10:32 pm
I think 6 months is grossly inadequate in this economy. Many of those programmers and software engineers laid off after the internet bubble collapsed took a lot longer to find a new job. I’d say 6 months to two years is more appropriate if you can afford it. Obviously, if you have high interest debts, these should come first – any extra payments you have to make every month is a drag. But I’d put 6 month to 2 years savings – I always think of my cash/CDs money as savings rather than an emergency fund – ahead of any kind of investments in the market or bonds or IRA.
I agree with posters above – it all depends on individual circumstances such as your job security, expected severance, etc. Keep in mind that even if a company paid a severance in the past, it will pay it again.
February 18th, 2009 at 12:52 am
We run with 18 months in near and intermediate-term emergency funds. The near-term funds are in “high yield” savings accounts, and the longer-term funds are in I-bonds.
February 18th, 2009 at 8:18 am
Right now I’m trying to juggle building up an emergency fund versus paying down my debt. I’m finding a lot of mixed messages — some sources say not to bother with an emergency fund until you’re out of out debt.
My debt is a line of credit. Let’s say I use my current emergency fund of $5000 to pay it down, then I’m saving on monthly interest and my net worth stays the same. Let’s say an emergency happens and I need that $5000 — it doesn’t matter whether it comes from the line of credit or the emergency fund. Either way, I’m left with nothing in the fund, and $5000 off my line of credit.
But it’s very hard for me to think like that. I like having savings, but I hate having debt.
February 18th, 2009 at 2:21 pm
Beth, I’d pay off (or almost pay off) the equity line, then build up your savings. If you don’t itemize, the interest isn’t doing you any good anyway.
February 19th, 2009 at 12:21 am
I agree that the existing debt should be paid off first, assuming there is at least some form of safety net in the savings to protect you from an unexpected impact. Although the article clearly specified not to use credit cards, the fact is that in an emergency a credit card can be used to pull cash. Again, not recommended as the interest rate on this transaction would be very high.
The thought is that money in a savings account earning only 2-3% may be put to better use to pay down a debt at 12% (or higher).
But again, at least some savings should be considered a requirement before undertaking this movement of funds.